In the most recent Red Hot Penny Shares newsletter, I wrote, The JSE All Share and JSE Small Cap Index have hit 52-week highs. In fact, the JSE has not seen this many shares hit new highs in over a decade. While this is great news for SA investors and I expect more gains, I would like to make something clear today… Not all JSE stocks are equal! Simply put – in any kind of market, you often find “value traps”…
These are companies (or investments) that appear attractive based purely on its low financial valuation. And while as a value investor, I look at “cheap” companies, it doesn’t always mean they’re good buys.
So, it’s important for investors to look at more than just valuation to uncover value traps…
That’s why I’m going to share two indicators you can use to help you do this…
Value Trap Indicator #1: Is the industry’s outlook declining or improving?
Every industry goes though cycles – periods of growth and contraction.
During the growth stage, companies typically experience demand for their products and services. As a result, revenue and profits rise, cash generation is healthy, and dividends increase. The opposite is true when growth slows.
For example, commodities like iron ore, steel, lithium and a few others are currently in a down cycle. Take a company like ArcelorMittal (JSE: ACL), who’s the largest steel producer in SA.
ACL had a tough first half of the year with major losses due to slowing prices, and weak consumption from China’s local industries. As a result, its share price has crashed nearly 40% over the past year.
For some value investors, this seems like a prime opportunity to buy. To make it seem even more “attractive”, ACL sits on a share price of 125c (as I write this), compared to its net asset value per share of 591cps. But considering that the outlook for the steel market in the short-to-medium term is weak, you could be buying into a value trap – despite its cheap valuation.
Rather focus on sectors whose cycles are starting to rebound with improved sentiment. They present better opportunities to make money. Especially, if the companies operating within these sectors are profitable, cash-flush and attractively priced.
Value Trap Indicator #2: Are they heavily indebted?
In some case, debt can be good for a company…
But that’s only if they are leveraging that debt to grow its business and boost profits. In other cases, companies take on too much debt. Making it worse, they aren’t generating sufficient cashflows to lower its debt.
Then you still need to include interest payments on that debt. In high interest rates environments like today, profits and dividends typically get sacrificed.
That being said, companies that prioritise reducing debt by selling off underperforming assets can rejuvenate their balance sheets. And in turn, attract investors. Of course, this is often a case-by-case basis. But to give you an idea of how – if done properly and wisely – it can boost share prices, just look at Nampak (JSE:NAM).
The company is in the midst of a massive business restructure by selling off its African assets. Not only is this a good move as many businesses struggle to grow in Africa, but it also helps shore up Nampak’s balance sheet.
The result? Its share price is up +116% in 2024!
Sure, it was a risky bet at the beginning of this year. And I get that some investors prefer not to take these types of risk. If you fall into this category, rather focus on stocks that hold 10%, 20% even 50% of their market caps in cash, boast minimal or zero debt, and are profitable. You really can’t go wrong here.
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