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Please Keep This in Mind If You Want To Buy Value Stocks

It’s not uncommon for investors to want to hunt for value stocks. After all, buying stocks when they’re cheap helps stack the odds of success in our favour.

But, the hunt for value stocks can become dangerous if investors focus on superficial valuation metrics, like say, the price-to-earnings (P/E) ratio. I was reminded of this by a recent interview my U.S. colleague Rana Pritanjali had conducted with renowned valuation expert, Professor Aswath Damodaran.

Here’s the particular exchange in the interview that triggered my thoughts (emphasis is mine):

Rana Pritanjali: What do you think investors mean when they say that “This is a value company now”?

Aswath Damodaran: You know, what I hear is that they probably found that the P/E ratio is less than 10. Another aspect of the laziness that characterizes so much of old-time value investing.

When I hear the word “value stock,” what I usually hear is that you looked at the P/E ratio for the stock. It’s lower than the average, so you’ve decided to call it a value stock, or it has a big dividend yield, therefore it’s a value stock. If that’s your definition of a good value, I think you’re in serious trouble.”

A great example of the danger that a blind focus on superficial valuation metrics can bring is Swiber Holdings Limited (SGX: BGK).

Swiber's PE ratio from 1 January 2012 to 31 December 2013
Source: S&P Global Market Intelligence

You can see in the chart above how Swiber’s P/E ratio had only briefly breached 10 from the start of 2012 to the end of 2013. In fact, the P/E ratio was bouncing between 6 and 8 most of the time. So, Swiber’s P/E ratios in those two years were really low.

For perspective, consider that (1) in the five years ended 31 December 2011, Swiber’s P/E ratio had averaged 13, and (2) the Straits Times Index (SGX: ^STI), Singapore’s market barometer, had an average P/E of 16.9 from 1973 to 2010.

Yet, an investor who bought Swiber’s shares at any point in time between 2012 and 2013 would be sitting on some horrible losses right now. The company’s share price had ranged from S$1.57 to S$1.03 in that time frame. Swiber’s shares are currently suspended from trading, but they were exchanging hands for just S$0.109 each just prior to the suspension. That represents a maximum loss of 93% from the prices seen in 2012-2013.

The company’s stunning share price decline since 2012 can largely be explained by its business performance. A profit of S$0.202 per share at the start of 2012 had become a loss of S$0.076 per share today.

A low P/E ratio can’t do much good if a company’s business would go on to perform poorly – Swiber is a great reminder of this idea. Keep this in mind if you want to buy value stocks.

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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.