Don’t Fall Into This Investing Trap

Danger sign

When we try to look for value in the stock market, a low Price-to-Earnings (PE) multiple would likely be an important requisite. The idea is that by investing in a stock with a low PE, poor future expectations about the business’s performance have been baked in by the market and any modest but pleasant surprises can move the stock price upwards.

In David Dreman’s book Contrarian Investment Strategies: The Psychological Edge, he cited his own study of US stock market returns from 1970-2010. In the study, stocks were divided into quintiles based on PE and the annual returns for stocks in the lowest quintile averaged 15.2% for four decades, handily beating the market’s return of 11.6%.

Other investors like James Montier have also conducted studies based on low PE stocks and found that over time, a basket of such stocks generated market-beating returns.

So, a low-PE strategy does seem to pay off well. But, as it is with all investing strategies, there are risks involved. A low PE share can sometimes turn out to be a value trap. Value traps are shares that appear cheap on an outward basis (usually by some measure of value, such as PE) but whose underlying business is fraught with difficulties which might never be overcome.

How can we avoid value traps? The best way to do so would be to ensure the company can survive financially. Benjamin Graham was the father of value investing and he liked to buy his stocks cheap but he was always wary of debt.

Let’s consider a company like Pacific Andes Resources Development (SGX: P11), which operates fishing vessels and then sells its harvest. Its shares currently trade at $0.138 with a PE of 4.9, way below the Straits Times Index’s (SGX: ^STI) PE of 13.2. In the company’s first quarter of financial year 2013, it had an interest cover of only 2.6 (earnings before interest & tax (EBIT) of HK$362.1m, and interest expense of HK$141.0m), which is low.

Furthermore, the company carries HK$9.95b worth of debt and only HK$306.3m in cash on its balance sheet, putting the company in a dicey financial position. If there are any adverse changes to the company’s business, it will have trouble servicing its debt-interest payments and face severe difficulties in debt repayment. In a situation like this, a low PE share might well turn out to be a value trap.

Foolish Bottom Line

Value investing legend Walter Schloss has been quoted as saying he ‘doesn’t like debt because it can really get a company into trouble. I prefer to buy basic businesses with strong balance sheets’. While trawling the market for low-PE bargains, it pays to also keep an eye out for debt-laden balance sheet –lest you find yourself falling into a value trap.

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The Motley Fool’s purpose is to help the world invest, better. The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Contributor Chong Ser Jing doesn’t own shares in any companies mentioned.