As a smart investor, you should always be on the lookout for what are known as value plays.
These are simply quality stocks that due to some market mispricing have traded at a discount to their intrinsic value (IV~ the sum total of the business’s worth based on earnings, dividends, equity and debt).
However, you need to be careful not to assume that all blue-chip stocks trading at a discount to (IV) are automatically screaming buys.
If you don’t keep an eye on a stock’s underlying business, and where the profits are coming from, what you thought were buying opportunities could turn out to be accidents waiting to happen.
There’s no shortage of one-time large-cap stocks listed on the ASX which, regardless of their market capitalisation, have crashed and burned, and Babcock and Brown, HIH Insurance, Nylex and ABC Learning are four extreme historical examples.
Price and value inevitably converge
Remember, the world’s most successful investor and champion of value investing Warren Buffett buys undervalued "quality stocks" in the knowledge that price and IV will at some future point converge - and there’s sufficient evidence to suggest that this is true.
But the rot can set in if you simply assume that a former blue-chip can replicate its former glory days, and it’s becoming increasingly clear that their best days might be behind it for any number of reasons.
Commonly referred to as “value traps”, these are stocks that you may have bought into when they appeared cheap based on (low) multiples of earnings, cash flow or book value and trading below their IV.
However, if after an extended time period the stock never improves, there’s a strong likelihood that you’ve fallen into a value trap that needs to be dealt with before it gets worse.
Given that value traps rarely improve, it’s better to cut losses, and deploy funds into the market’s next best opportunity than simply riding your losses down.
Indeed, there might be a future buying opportunity to enter a former value trap that’s been bought out by private equity that plans to implement a robust turnaround strategy.
But this is a completely different proposition, and the risks of paying too much for this underlying growth story – which may not deliver – are high.
One of Buffet's value investing touchstones is the desire to understand businesses and not just treat the share market like a casino governed by share price momentum.
Governed by more short-term drivers and media hype, share prices can and do vary enormously over a year, whereas real business fundamentals tend to be much less volatile.
Look beyond the P/E ratio
The lesson for new or misinformed share investors is that a discount to IV or low price earnings ratio (P/E) doesn’t always mean 'cheap'.
While some stocks trade at a significant premium to their value (IV) for good reasons, the opposite can also be true.
So as a litmus test of value, the P/E ratio can be and often is highly misleading. Take for example insurers, cyclical businesses, and the materials sector, where the businesses often have high profits and consequently low price earnings ratios at the very moment when conditions are at their best.
Sadly, investors who choose shares under the psychological $1 barrier often confuse affordability with value.
Similarly, many investors consider 'blue chip' companies with a strong brand name, a high profile and a long history of good performance as perennial bellwethers when they’re clearly not.
Due to any number of factors, whether it’s poor management, deteriorating economic factors or industry-related issues, stocks that fall into the value trap zone typically cannot retain market share in the face of new competition.
The danger of holding onto emerging value traps is that by the time the company’s deteriorating fortunes become obvious to the broader market, the gap between the price you bought the stock at and its value is widening.
Watch the results carefully
Given that reporting seasons can be full of surprises, it’s important to stay on the lookout for stocks with disappointing results, together with negative commentary on the outlook for a business or the competitive edge it once enjoyed.
The trick is to anticipate what damage reporting season will have on a stock’s value before re ratings occur.
Many investors will be surprised to see the discount to value they thought some companies were trading at look totally different by year’s end.
The net effect is that while one sector might look attractive when compared with current earnings, sector-specific issues and other macro headwinds may pose major risks to buying these stocks going forward.
