Avoiding value traps is the key to stock market success

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Value investing, like bargain hunting, is about buying companies that appear to be cheaper than what they are worth. This often means buying companies that are out of favour with investors. In some cases, these companies may have been too oversold, and investors can make great returns when they return to their intrinsic value.

However, the danger is that investors buy into value traps. Sometimes a price fall is justified due to poor financial and growth prospects or the poor management of a company. These stocks can become value traps and avoiding them is important. There are a few methods savvy investors utilise to avoid them.

The concept of value was developed by economists Benjamin Graham and David Dodd in the 1920s. Their book Security Analysis (1934) and Graham's later book The Intelligent Investor (1949) introduced investors' methods that could be used to identify value.

avoiding value traps

Graham and Dodd believed that the true value of a stock could be determined based on its assets, future earnings, dividends and prospects. The lower the price of the security relative to this intrinsic value, the higher the margin of safety. Graham and Dodd developed value investing - that is, buying shares priced well below their intrinsic value. Behind this concept of value investing is the belief that cheaply valued assets tend to outperform more expensive stocks over a long horizon.

Over the very long term this has proven to be true. One of the world's most successful investors, Warren E. Buffett has made his fortune since using the principles of Graham and Dodd's as the CEO and shareholder in Berkshire Hathaway Inc. Buffett has made a career identifying value when others have been selling. Key to his success has been identifying real value stocks and avoiding companies with poor financial and business prospects.

That's because a low price alone does not indicate good value, and those who pursue low price alone can easily fall into value traps, or trying to catch a falling knife.

The possibility of these value traps means investors have to consider beyond traditional value and look ahead. The use of forward earnings estimates can help mitigate the potential for investing in value traps, according to MSCI.

MSCI's Enhanced Value Index applies three valuation ratio descriptors on a sector relative basis:

  1. price-to-book value;
  2. price-to-forward earnings; and
  3. enterprise value-to-cash flow from operations.

Compared to a traditional value approach, MSCI's enhanced value overcomes many of the criticisms of value because it puts less weight on price-to-book as a metric and moves away from backward-looking metrics such as dividend yield. MSCI's approach uses a whole-firm valuation measure in enterprise value which could reduce concentration in leveraged companies.

Moreover, the current macroeconomic environment may favour value investing. Value is pro-cyclical, meaning that this type of strategy historically outperforms during inflationary periods and when economic growth is relatively strong. MSCI has recently examined how different equity factors have performed in different inflationary environments from December 31, 1979, to May 31, 2021.

The index provider found that value, small caps, and low volatility stocks performed best during periods of high inflation, while growth performed best when inflation was low.  Reflecting that, the MSCI World Value Index outperformed MSCI World Growth by 1.11%, in Australian dollar terms, over the six months to July 31, 2021.

And inflation is definitely rising. The consumer price indexes (CPI) of G-7 economies posted the largest increase in the second quarter of 2021 since the end of global financial crisis in 2009. Notably, the US consumer price index struck 5.4% in June 2021 compared to 12 months previously, the fastest growth rate since 2008

Traditionally, there has only been one way everyday investors have been able to gain exposure to a 'value' portfolio, high fee active funds focussed on identifying value opportunities. To date, only institutional investors have been able to access low-cost passive international value investments.

Value investing has come a long way since the days of Graham and Dodd, but the underlying principles remain the same: identifying companies that appear under-priced using fundamental analysis, and investors can access value investing via ETFs.

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Arian Neiron is managing director and head of Asia Pacific at VanEck.