Over the very long term, value investing has been shown to be one of the most successful strategies for building your wealth. Nevertheless, distinguishing between genuine bargains and value traps isn’t easy. Here are a few suggestions on what to look out for.
Go beyond the P/E
Perhaps the biggest mistake to make when hunting for value is to assume that a company’s price-to-earnings (P/E) ratio tells you everything you need to know about whether its shares are a good deal or not. After all, a business can look a steal on its current valuation but less so when compared to its long-term average.
Context is also important. When you think about it, we’re all value seekers in the sense that we’re all trying to make money by purchasing stakes in companies and selling them at higher prices at a later date. Seen in this way, shares trading on a fairly expensive-looking P/E of 20 could still be a great deal if prospects look good and the company is on a lower valuation to (possibly inferior) peers. Conversely, a cheap looking company may be an awful buy if it’s in a declining industry. Irrespective of how good management may be, it’s hard to make money from selling things that nobody wants or needs.
Check but don’t fixate on the P/E ratio. See the bigger picture.
Look for the moat
Regardless of their current price, quality value stocks tend to be those that still possess some kind of advantage over the competition, otherwise known as an economic moat.
Some of the FTSE 100’s mining giants would have been excellent contrarian buys back in January 2016. As a result of its size, diversified operations and cheaper production costs, BHP Billiton was able to weather to storm, even if its share price sank like many of its smaller peers and dividends were cut. If you’d bought at the point of maximum pessimism, you would have doubled your money in less than a year.
Hindsight is all very well. Nevertheless, it always pays to ask whether there’s something about a business that makes it more resilient than those around it. It never did Warren Buffett any harm.
Solid financials
Sometimes, the market overreacts to bad news and presents investors with an opportunity to buy shares in an otherwise sound business. This is especially true for companies with manageable debt levels and strong free cash flow. After all, having stacks of cash may allow it to take advantage of opportunities if an entire industry is affected.
Debt can be useful in good times, of course, since it can allow a company to expand a fast(er) pace. Businesses with relatively stable revenue streams also don’t need to worry too much about what they owe. FTSE 250 funeral services firm Dignity would be a perfect example. UK mortality rates rise and fall but you’d struggle to find a more dependable source of earnings — worth bearing in mind should its shares temporarily plunge.
When it comes to investing in more cyclical companies with unpredictable profits, however, I’ve become very averse to buying anything that is more than slightly indebted. Any business whose finances could be severely tested if/when the market turns is not worth the hassle of investing in, regardless of how cheap it appears to be.