The Motley Fool

How Smart Investors Avoid Value Traps

Value investing is a strategy investors use to purchase stocks that are trading below their intrinsic values. It usually involves buying into companies that sport low price-to-earnings (P/E) or price-to-book (P/B) multiples.

However, investing in a company simply because it currently sports low P/E or P/B multiples without doing the necessary due diligence may result in accidentally buying into a value trap instead of a high-quality bargain. 

To avoid heartache, smart investors should know how to differentiate a value trap from a value stock.

Trailing P/E multiples are based on historical data

It is easy to get tempted to buy stocks that have low trailing price-to-earnings multiples. However, trailing P/E multiples are based on the company’s earnings over the previous 12 months.

In certain situations, the company’s earnings may not recur in the future. As such, the forward earnings can be much lower than in the past. Another concern may be one-off items that can artificially inflate earnings such as tax rebates, government subsidies, or other one-off income items.

Such companies, despite their low trailing price-to-earnings multiples, may be value traps that could continue to decline in value.

Is the company being disrupted?

It is not uncommon to find companies that have historically seen steady earnings suddenly face disruption due to the rapid rise in technology in recent years.

For instance, Singapore Press Holdings Limited (SGX: T39) previously enjoyed dominance as a news provider. However, the rise of the internet — specifically social media and online news — has changed consumer behaviour dramatically. Fewer people today rely on print newspapers for their daily news updates, and advertisers are shifting their marketing dollars away from traditional newspapers to more engaging and focused platforms.

The paradigm shift in the industry has resulted in SPH’s media revenue and profit declining steadily.

SPH’s share price has also continued to see P/E compression as investors realise the company’s problems are here to stay.

Weak balance sheet

Another important thing to consider is whether the company has a stable balance sheet. One red flag to look out for is a high net-debt-to-asset ratio. The net-debt-to-asset ratio tells us how much debt a company has in relation to its cash and assets. An overly leveraged company may face liquidity issues down the road.

Investors should also look out for a low interest-coverage ratio and a high debt-to-free cash flow ratio. A company with an inability to generate cash to pay off its debt or interest expense could require an additional equity injection or restructuring.

A great example is Hyflux Ltd (SGX: 600). In 2016, my colleague Chong Ser Jing pointed out that Hyflux had a “chronic inability to generate cash flow.” He also said that the company had a net gearing ratio of 0.98, which isn’t low. All of these were clear red flags that Hyflux would eventually run into liquidity issues, which ultimately proved prophetic.

The Foolish bottom line

It’s easy to get tempted by companies that look cheap on the surface. However, bargain-hunters should always consider the ecosystem in which the company operates. It’s also important to look for any one-off items that may artificially inflate a company’s earnings. Lastly, a thorough analysis of the balance sheet is essential to prevent yourself from falling for a value trap.

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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 Jeremy Chia doesn't own shares in any companies mentioned.