Bargain hunters listen up! Here's how to AVOID the “Value trap” and discover the real undervalued profit-opportunities
What if I told you NOT all companies that appear undervalued will make you money?
This is one of the biggest challenges investors face.
In fact, professional investors refer to such undervalued companies as “value traps”
Typically, a “value trap” is a stock that seems cheap because it's trading at a massive discount to its sector, peers or net asset value for a period of time.
But don't be fooled…
There are four red flags that signal a value trap.
Read on to find out what they are…
Red flag #1: Profits are in freefall and show no signs of recovering
Take JSE listed ELB for example.
ELB’s share price is R17 while its Net asset value is R29.23. That means its shares are trading at a 72% discount. So it looks like a bargain but ELB just released a trading update and it expects profits to be 250% lower.
Earlier this year the company reported a 146% loss in profits. So would you a buy a company that’s losing a lot of money just because it’s cheap?
Key takeaway: Although you want to invest in companies that generate consistent earnings, earnings can be massaged, manipulated or completely fabricated.
But cash cannot. So make sure free cash flow is stable, or growing. If nothing less, it provides management with a little wiggle room, or margin of error when considering ways to speed up a turnaround.
Red flag #2: The company accumulates too much debt
A company can show great earnings, positive cash flow and growing sales. But it could still be in trouble if it’s accumulated too much debt.
You see, all it takes is a minor setback for the company to experience severe problems. And if this happens, the company could take years to turn back to profitability.
Key takeaway: To find out if a company is heavily in debt, you must analyse its balance sheet. This is an excellent place to start when attempting to avoid value traps.
You can look at a company’s debt to equity ratio, which shows you if the company is being financed with debt. Ideally, you want to invest in a company with a debt to equity ratio below 0.5.
You can also use the current ratio, which identifies if a company can meet short-term obligations with short-term assets. The higher the ratio, the better.
Red flag #3: The company operates in failing and troubled industries
The finer detail in a company’s financial report is just the beginning. You also need to know what industry it operates in, the performance and the future sustainability of the industry.
Also the general overview of the economy plays an important role in whether a company will grow its profits.
For example: I mentioned in red flag #1, how ELB has recorded a massive drop in profits. One of the main reasons why is because, the group operates in tough SA sectors like engineering, industrials, mining and construction, which are experiencing a slowdown in production, rising costs and slow economic growth.
So while the company is trading at an extremely attractive discount, it’s for a very good reason – consistent drop in profits and struggling industries.
Key takeaway: You can also check for monthly reports revealing data about South Africa’s mining, agricultural, manufacturing industries and also economic growth. This will tell you what’s performing and what’s not.
Red flag #4: Management’s unable to identify opportunities to boost the company’s profits
To truly detect and avoid value traps, you mustn’t analyse key financial ratios.
A company can have great numbers, good growth and great potential, but if management is unable to identify and invest in strategic businesses to boost its profits, then it could plunge into trouble.
For example, you want to see a company generating profits from different sources or earning profits in different currencies. You want to see a company launch a new product or buy a new business venture.
Key takeaway: Look in the company’s financial reports and analyse its core business and investment strategy.
Here, you’ll find out what it’s invested in, future business plans, key prospects and outlook for the future.
Until next time,
Knowledge brings you wealth,
Joshua Benton Real Wealth