The Danger of Being a Deep Value Investor

The simple idea of investing is to invest in a company at an attractive price. It is the idea first promoted by Benjamin Graham. Today, investors who focused on finding cheap bargains in the stock market are often called, “Deep Value Investors”.

Over the years, I have met many great investors who have been very successful in the stock market by applying the strategy of being deep value investors. However, this strategy is not without risks. I have also met many investors who have fallen to the greatest risk of practising this type of investment strategy.

The Main Risk

The main risk of being a deep value investor is the risk of investing into a value trap. A value trap is a type of investment which seems cheap based on the traditional financial ratio analysis. The company might have a decent return on equity, a low debt level and an attractive valuation.

This means that by any financial measure, such a company would be a great bargain. However, the investor might have missed some of the more qualitative aspects of the business.

For example, in many cases of deep value stocks, there might be a reason why these companies are trading cheaply. It might be because of the reluctance of its top management to improve the company, or it might be due to dishonest management. Whatever it might be, the hidden value in these companies would need a “catalyst” to initiate the change. Without a change in the situation of the company, there would have no reason why its value will be fully realised.

However, if the investor fails to spot this need for a catalyst, he might have invested in a value trap. This means that this “cheap” company might just continue to be trading cheaply due to the inherent fundamental problem within the company.

Foolish Summary

Being a deep value investor can bring about great success in the stock market. However, the strategy also comes with some risks. One of the main risks is the risk of buying into a value trap. Investors need to be aware of this risk in order to correctly practice the strategy of deep value investing.

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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 contributor Stanley Lim doesn’t own shares in any companies mentioned.