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Investors: You Have To Beware (Some) Cheap Stocks

Singapore’s stock market may reasonably be deemed to be cheap at the moment.

The SPDR STI ETF (SGX: ES3) – an exchange-traded fund tracking the fundamentals of Singapore’s market barometer, the Straits Times Index (SGX: ^STI) – has a trailing price-to-earnings (PE) ratio of just 11.4 at the moment. That’s a fair bit lower than the Straits Times Index’s own long-term average PE ratio (from 1973 to 2010) of 16.9.

With the Straits Times Index already being at a discount to its historical standards, can shares with lower PE ratios than the index be considered as even greater bargains? Well, it depends.

A lookback at history: When cheap kills

The Straits Times Index had fallen to dirt-cheap levels back in 2009; at the start of that year, it was valued at just six times its historical earnings. According to S&P Capital IQ, there are 279 shares listed in Singapore today that had PE ratios lower than six back then (I had ignored shares with negative earnings).

You would expect those 279 crazy-cheap shares to be big market winners today. But interestingly, 113 of the group of 279 have lower prices currently as compared to the start of 2009. And, that has happened even as the Straits Times Index has gained more than 50% over the same period.

Turns out, 111 of the 113 low PE shares – that’s nearly all of them – which have seen their shares decline since the start of 2009 have actually experienced falling earnings. It’s a great reminder for all investors that shares with cheap valuations can still become horrible investments if their underlying businesses become worse over time.

Some yellow flags

Some shares with a trailing PE ratio of less than 11.4 now include Ezra Holdings Limited  (SGX: 5DN), Ying Li International Real Estate Ltd  (SGX: 5DM), and China Yuanbang Property Holdings Ltd  (SGX: BCD). The trio are cheaper than the market at the moment, but there are reasons for investors to proceed with caution with these stocks.

The three companies seem to have experienced a severe deterioration in the economics of their businesses over the past few years given their shrinking returns on equity despite the use of higher leverage. You can see these in the table below (click for larger image):

Ezra, Ying Li, China Yuanbang ROE and TDE

Source: S&P Capital IQ

A combination of potentially pricier debt (given the possible rise in interest rates in the future) and poor economics can be a poisonous cocktail for future returns. Investors who are attracted by the low valuations of the three stocks mentioned would have to be confident that their businesses won’t crumble in the future.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.