Investors often act unwise when choosing stocks
Assuming, for example, a share has a P / E of four and a P / E of 0.2, it looks attractive at first glance – as it is particularly undervalued. Investors often put such low-valued stocks in their portfolios and then hope for price increases. After all, such undervalued stocks should be able to gain in price. But caution is advised. It is not uncommon for investors to experience shipwreck with such value stocks. The market often knows why it rates such companies so low. Losses can threaten.
Some of the low-valued, i.e. cheap stocks – later turn out to be so-called value traps – as investor traps that destroy value and were therefore not real value stocks. To circumnavigate these is a certain art, similar to how ship captains, with the support of their crew, manage to avoid icebergs that are not superficially visible in the sea. In this case, certain auxiliary instruments and the experience of the captain and the crew can be used in shipping. There are also options for avoiding value traps, which are explained in more detail below.
How can investors avoid value traps?
In order to avoid value traps, for example, investors can first deal with the competitive situation of the undervalued public company. A paper by Perkins Investment Management – a subsidiary of Janus Capital Group Inc. – from September 2016 entitled “Beware: Value Traps Lurking: What to Look for and How to Navigate Potential Pitfalls” refers to this.
Afterwards, future risks for the company are to be analyzed with the help of the 5 competitive forces model once developed by the US marketing guru Michael E. Porter. If the competitive situation is bad and the situation could even get worse, then the price decline, which often leads to favorable valuations, is perhaps entirely justified.
In addition, however, the balance sheet situation of the company to be analyzed also plays a major role in the paper. For example, if the debt is too high and the equity too small, future losses may no longer be shouldered. But also the solvency, i.e. the cash stocks and also the debt management should be kept in view in the course of the analysis.
Furthermore, the assessment of the company could be seen in comparison to the overall market, the industry and its own history, and the management and its quality may also have to be taken into account.
In summary, according to Perkins Investment Management, the risks of falling into a value trap can be reduced if the company is well positioned in terms of accounting, has consistently strong free cash flow, has stable profits and is competitive.
Pay attention to catalytic converters and special situations
With a view to avoiding value traps in undervalued stocks, experts often also focus on so-called catalysts. Catalysts are conditions that act as “ignition aids”, e.g. for an improved profit situation. Such a catalyst for cyclical stocks would be, for example, the general economy, which is picking up speed. Many cyclicals tend to be dependent on the economy and, if necessary, can significantly improve their profit situation in the event of a strong economic upswing. Rising profit prospects should then tend to help the share prices of cyclicals and act as a “starter” for a rally. For companies that produce raw materials, a rise in the price of the respective raw material would also be a possible catalyst for a share rally. For example, a copper producer who has seen a massive drop in the share price due to a fall in the copper price and is therefore valued favorably, should be able to benefit from a sustained rise in copper prices.
In the case of more defensive stock companies – e.g. companies from the non-cyclical consumption sector – there is now and then a true undervaluation, because the stocks are either dragged down by a general market panic or special situations depress the prices. A possible special situation would be, for example, a hygiene scandal at a food company that depresses profits in the short term but has no long-term negative effects. Since experience shows that market participants tend to exaggerate when the news is bad, the company’s share price could be so depressed due to the scandal that the company is now turning out to be a bargain with a view to a longer-term investment.
Value approach à la Benjamin Graham
Benjamin Graham’s very special value approach is another aid to avoiding losses at the overall portfolio level. Graham (1894-1976) – world-famous value investor and foster father of Warren Buffett – recommends a healthy company balance sheet when it comes to making a selection of real bargain stocks. Shortly before his death, Graham stated in an interview with the medical journal “Medical Economics” in 1976 that the equity capital of public companies should amount to at least 50 percent of total assets.
In the hunt for real stock bargains, however, there is another number to look at, according to Graham: The P / E ratio. According to Graham, the P / E ratio should be a maximum of 7. Not higher. A portfolio of at least 30 public companies with a P / E ratio of no more than 7 and an equity ratio of over 50 percent then represents the minimum, according to Graham.
Graham also gives certain rules in the interview, for example how to deal with losing stocks in the portfolio, how long the investment horizon of stocks is usually and which particular P / E ratio an investor should focus on.
With the help of the two easy-to-use key figures P / E ratio and equity ratio as well as just a few additional rules, according to Graham, an average return of 15 percent p.a. or higher could be achieved in the long term. Given an expected average annual return on the US stock market for standard stocks of around nine percent, the bargain stock portfolio according to Graham would clearly outperform the overall market. So cheaply valued and solidly funded public companies would be a good choice for long-term beating the general market. The few rules provided ensure that “blown guns” do not haunt the portfolio permanently.
Investors should not make the mistake of rushing to buy cheap stocks that have very low P / E or P / E ratios, for example. In addition to a mere fixation on a low rating, quality should also be emphasized in order not to fall into the famous value trap. A healthy financing structure in the company’s balance sheet could serve as an important quality standard. In addition, a good competitive position and good management quality should help to reduce the risk of a value trap. If there are then certain catalysts that could increase the profit situation, profitability, etc., an early equity rally should tend to be possible.
Finanzen.net editorial team
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