Value Investing and the Value Trap
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Value Investing and the Value Trap

The value investing strategy relies on finding fundamentally sound company stocks that are trading at a discount to their actual or intrinsic value. That situation can happen for all sorts of reasons. A stock (business) may be unpopular with investors because it is temporarily out of fashion, goes against a general market trend, or is off the market radar. But they are not the only reasons a stock may be cheaper than it really should be: stocks may be undervalued for other, more worrying reasons.

the basics

To determine whether or not a stock is undervalued, value investors look at a company’s financial fundamentals. They will examine a variety of ratios including, but not limited to, earnings per share, PEG, P/E ratio, dividend yield and payout ratio, book value, price/book value, price/sales ratio, and return on equity. No matter how meticulous the analysis, sometimes some of these ratios can be misleading, with earnings per share (EPS) being one of the main culprits. EPS is widely considered to be one of the most important ratios because it shows how much of a company’s earnings goes to each stock. But the fact is that when the EPS figure rises, it doesn’t always follow that earnings rise accordingly. Although two companies may have very similar EPS, one company may need substantially more share capital to generate the same EPS. Of the two, the more attractive option for the value investor would be the business that requires less capital.

The margin of safety

Serious value investors don’t take shortcuts. To help them decide whether or not a stock is undervalued, the investor will want to look at as many of the company’s fundamentals as possible and practical, that is, he will look for as many stones as he can find. When that quantitative analysis identifies an apparently undervalued stock, the next consideration is ‘undervalued yes, but by how much?’ Because capital preservation is a key issue for value investors, they like stocks that provide a high Margin of Safety (MoS). The MoS is the difference between the current (depressed) price of the stock and its actual market price; the larger the difference, the higher the MoS. And the higher the MoS, the better protected the investor’s capital against any errors made in its calculations or, indeed, any post-purchase and substantial market volatility.

the emperor’s clothes

But even when some of the ratios look favorable, a cheap stock may not be as cheap as it seems and may actually deserve to be cheap, or even cheaper than it already is. There may be issues that the company’s financial statements cannot or are not designed to calculate or disclose, some of which include:

Are the company’s products outdated?
· Is the sector in decline?
· Is the management team up to the job?
· Is competition increasing or getting smarter?
· Is the business model flawed?
· Does the company have too many debts?
· Are questionable or unconventional accounting procedures being applied?
· Is there a whiff of scandal, corruption, or corporate governance issues?
· Are earnings estimates revised more often than they should be?
Has the company grown solely through acquisitions?

Morality is:

While the metrics may be compelling, some undervalued stocks are fully deserving of their low rating. Depending on the quantitative analysis alone, it may only provide a few clues as to why a stock is as cheap as it is. There is absolutely no question that unpopular stocks can be good investments: the art is to invest only in those that are best placed to recover from their problems.

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