Don’t Make This Mistake While Investing

Credit: Terrance Heath

I had dinner yesterday with a group of friends who are keen investors. During our conversation, one of them brought up a lesson he had picked up over the years: A stock which looks attractively cheap can easily become a big loser if its business does poorly.

What my friend said is worth remembering. Buying stocks with low valuations without deeper thought of the business – ‘I’m buying this just because it looks so cheap!’ – is one mistake we should all strive to never commit.

My Foolish colleague Chin Hui Leong had suffered through this before and he has graciously allowed his experience to be shared for the sake of letting others learn.

On 5 May 2009, he purchased shares in American Oriental Bioengineering, a US-listed China-based pharmaceuticals company. It was a cheap share – at that time, it was valued at only 7 times its trailing earnings.

But cheapness couldn’t save the investment. In 2009, American Oriental Bioengineering had made US$296 million in revenue and US$41 million in profit. By 2013 however, the company had made a loss of US$91 million and its top-line had shrank by more than half to US$122 million.

Despite the US stock market – as represented by the S&P 500 – having grown by 113% from 5 May 2009 to today, Hui Leong’s American Oriental Bioengineering shares have slipped to US$12 each from his purchase price of US$4,469 apiece (no… that’s not a typo; the comma isn’t a decimal).

Billionaire investor Warren Buffett once said that “If the business does well, the stock eventually follows.” The reverse of that – if the business does poorly, so too the stock – holds water as well.

We can see that in Singapore’s stock market with commodities trader Noble Group Limited (SGX: N21) and shipbuilder Cosco Corporation (Singapore) Limited (SGX: F83) being illustrative examples.

Noble and Cosco Share Price, Valuation, and Earnings table

Source: S&P Capital IQ

As you can tell from the table above (click for large image), both companies were trading for low single-digit PE ratios at the start of 2009; both still ended up being lousy investments over the long-term largely as a result of their businesses’ drastic declines (alluded to in the lower earnings). Bear in mind too that this has happened despite the Straits Times Index (SGX: ^STI) having gained nearly 60% over the same timeframe.

There are likely to be many stocks in Singapore which have attractive valuations now given that the Straits Times Index is currently in bear market territory after falling more than 20% from a peak this April.

But, when you’re sniffing around for opportunities, keep in mind Hui Leong’s experience as well as my friend’s wise words. Do not blindly invest in something just because it looks cheap.

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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 companies mentioned.