Sometimes one comes across what seem like cheap shares. Maybe they sell at just a few times their earnings, or else look inexpensive relative to explosive growth prospects enjoyed by the business.
But what looks like a cheap share can turn out to be a value trap. Here are three red flags I look for when I find shares that seem cheap at first glance.
1. Exceptional earnings
Sometimes companies benefit from a sudden but ultimately unsustainable surge in earnings.
That is the story of latex manufacturer Synthomer, for example. As demand for items like surgical gloves soared in the pandemic, so did its profits and dividends. But that was not bound to last and the company has since cancelled dividends.
If I had bought Synthomer a year ago based on its recent performance, I might have tumbled into a value trap. The shares have fallen 46% since then.
Yet I think Synthomer is a good company and has attractive long-term prospects! The issue I would have faced buying a year ago and holding until now was not that Synthomer is a weak business, but rather than it was overpriced 12 months ago relative to its future prospects.
A value trap does not have to mean that I buy into a rotten business. It can simply mean that I buy into an excellent business but at a rotten price.
A common reason for that is looking at a company’s past earnings, without assessing its future earnings potential rigorously enough. No matter how often we are told “past performance is not necessarily a guide to future performance”, it remains true.
2. Dragged down by debt
That is not the only way one can mistakenly identify supposedly cheap shares when using a price-to-earnings (P/E) ratio as a valuation metric.
Sometimes a company might look very cheap when comparing profits to market capitalisation. But market capitalisation is not the same as enterprise value. Enterprise value also includes a company’s net debt or cash.
For example, tobacco manufacturer Imperial Brands trades on a P/E ratio of less than 8. That looks cheap. But it ended last year with net debt of £8.5bn. That was 9% lower than the prior year but it is still substantial.
In 2020, the Rizla maker cut its dividend as it prioritised debt reduction. A lot of debt on the balance sheet is always an important factor for an investor to consider when deciding whether to invest.
3. Probability problems
Sometimes investors look at miners selling for pennies per share and reckon they have found cheap shares.
Maybe they have – but often they have not.
When considering the value of a share, simply thinking about how much money the business could make if it does well is not useful in my view. In fact it can be positively dangerous.
I think one also needs to consider objectively the probability of a particular outcome. As an investor, I try to get clear on the range of possible outcomes — but also the probability of each one happening.
