Everyone loves a good bargain. There is something satisfying in the knowledge that you have found something priced for less than what it should otherwise be worth. In other words, you get a good bargain when you paid less than what you would usually expect to pay for the same item.
In investing terms, finding an undervalued stock is akin to finding a good bargain. An undervalued stock could be trading at a market price below its net asset value (NAV). However, buying low at times does not necessarily mean you may get to sell at a higher price. These are stocks are what we call “value traps”.
What is a value trap?
A value trap refers to a stock that could have good valuation ratios, but may not be a value buy because it does not have good fundamentals. Such stocks, which may appear cheaply priced, may remain cheap for a long time or even fall. In the worst-case scenario, the price of the stock may never reach the same levels as it did when you bought it. This normally depends on the number of investors buying into the same stock.
How do you identify a value trap?
To identify a value trap, you first need to know what constitutes a fundamentally good stock. Beyond the usual valuation ratios like price to earnings (P/E) and price to book (P/B) or price to net asset value (P/NAV), a fundamentally good stock must also enjoy good prospects. After all, a stock that enjoys a bright future has a higher chance of seeing its stock price increase. The increase reflects investors’ expectations that the company’s customers will be consuming more of its products, which increases the value of the company. Determining a company’s prospects can be done by taking a closer look at the ongoing macroeconomic and societal trends today. Here are several other ways of identifying a potential value trap.
• Look into a company’s assets
Another way to identify a value trap is by looking into a company’s assets and liabilities. You will be able to find this in the company’s balance sheet. The balance sheet is where you will find a company’s financial position at a particular point in time, which is usually at the end of every fiscal quarter.
A company with a positive NAV has more assets than liabilities. This includes cash and cash equivalents. For instance, if a company has a NAV of $10 per share, it means that the company has $10 worth of surplus assets per share in its capital. And if that same company’s share price is at $5, you are essentially buying the company for $5 but are getting back $10 worth of assets or NAV.
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When people analyse a company’s balance sheet, they are gauging how financially sound the company is. A positive balance sheet means that should the company wind up, you, as a shareholder of the company, should still make some money off your investment.
• Know which assets matter
Not all assets are created equal. By this, we mean the different assets and liabilities in a company may not necessarily be valued correctly unless it is cash. This is why it is important to look closely at a company’s balance sheet for the composition of a company’s assets.
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The same asset can be valued differently by different valuers. Such assets usually refer to property and capital-heavy assets.
Liquidity refers to the ease with which an asset is converted to cash. Within the balance sheet, a company’s cash equivalents and shortterm cash equivalents are the most liquid. The same applies to a company’s money deposits and bank savings.
Illiquid assets, on the other hand, refer to things like property, equipment, inventory or merchandise. Should the worst happen, these assets may need to be sold off to pay debtors or keep the company afloat but there is no guarantee a seller could be found or that the asset can be sold for a good price.
The more illiquid an asset is, the less accurate its value may be as valuations may have changed.
• Look beyond a company’s P/NAV
Companies that usually trade at very low P/ NAVs tend to have little cash. For instance, companies that are trading at a P/NAV of 0.5 times and below are usually companies that own more illiquid assets than cash as illiquid assets are harder to value. However, the right valuation will only determined when a sale takes place.
Furthermore, in the event of a company going under, there is the possibility of a company holding a fire sale, where it may be forced to sell off its illiquid assets at steep discounts.
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In that case, if there is $10 on the company’s asset per share and $9 of it is made of illiquid assets, that $9 may not be worth $9 due to the fire sale the company is forced to undertake. These assets may eventually be sold for $3–$4 per asset during desperate times. When that happens, the company’s actual asset per share will be lowered by $5–$6, which means the company’s balance sheet may have a smaller surplus or go into the red depending on the amount of liabilities it has at that point in time.
• Assessing the value of a company’s assets accordingly
While every analyst has his or her way of analysing a company’s assets, at The Edge Singapore, whenever we do valuations on a company, we apply a discount on every asset based on how liquid it is.
Inflation aside, cash is cash, and no discount needs to be applied. However, with assets like property, there will be a 70% or 80% discount applied to every $10, depending on the nature of its use. If the property is for investment purposes, a lesser discount will be applied. Other types of properties like the actual office the company is operating out of will have a heavier discount applied.
The nature of the company’s business matters too. For property development companies that have a higher proportion of investment properties within their assets, a lesser discount will be applied due to the more liquid nature of such properties to the business.
At the other end, if the company we are scrutinising is in the offshore oil and gas industry and the company has several sea-going vessels it classes as assets, the discount applied will be a much heavier one, especially if the vessel is an old or outdated one.
This method of applying discounts is also relevant to a company’s receivables, which can also be found in its balance sheet. The longer the receivables take to be received by a company, the greater the discount. The longer the timeframe taken to receive the sum or asset, the more uncertain the valuation of the asset will be.
• Look at the company’s free cash flow
Finally, a company’s cash flow statement is also one way to determine whether the company you are buying into is a value trap or not. A company that has positive free cash flow is a good indicator that the company is growing in value or NAV over time. Conversely, a company that has negative free cash flow means that it is shrinking in value or NAV over time.
Should the trend of decline continue with no clear change in sight, the company may end up having a negative balance sheet, which could lead to its eventual closure. If a company is consistently losing money, it diminishes its NAV over time and it may take some time before it could be wound up.
When that happens, its share price may also reflect its decline. This means you may get trapped at the higher price that you bought the stock at a while ago, if you are not careful.
A company’s cash flow statement also reflects the debt paid or taken by that particular company. In this case, investors should be wary of companies increasing their cash balances by increasing debt. If the company is unable to pay its debt off, then the debt would add up on the liabilities side of the balance sheet.
Essentially, before buying into any publicly-listed company, a deep dive into its books is a must to prevent getting caught in situations where you cannot cash out at a premium to your entry price.
