Equity investment: How to separate value stocks from value traps

April 19, 2019 12:25 AM

Cheap stocks with a high composite quality score are more likely to be the true value stocks, while the rest of them are likely to be classic value traps.

Equity investment: How to separate value stocks from value trapsEquity investment: How to separate value stocks from value traps

By Mayank Joshipura

Investing is simple but not easy, said Warren Buffett. Many of us may want to follow the investment philosophy of Buffet and want to follow his value investing principles but as he mentioned, it is simple but not easy. Both Buffett and Charlie Munger realised in the early days of their investments that one can’t trade quality for cheapness. They preferred buying quality businesses at a reasonable price, when the price of such businesses had come down to a level that they believed would offer a lot of value and margin of safety.

Such opportunities arise due to a variety of reasons: a good company faces short-term difficulty and therefore the stock price comes down or a decline in overall markets brings down the prices of all the stocks regardless of their quality. However, such opportunities are few and most stocks that trade cheap or have come down sharply do so for a reason and are ‘value traps’ rather than ‘value stocks’.

The best way to avoid a value trap is to buy cheap stocks with a sustainable competitive advantage with good financial strength. Buffett gave a term ‘economic moat’ to describe sustainable competitive advantage and called for investing in businesses with a wide moat. Network effects, customer switching costs, low cost, intangible assets, regulated or natural monopolies are a few sources of this economic moat.

Let us try to create a simple five-step investment process to identify quality stocks trading at a reasonable valuation.

First, screen the universe of listed stocks by applying size and liquidity filter.

Second, minimise the chances of permanent loss of capital by screening stocks for possible financial reporting fraud and high probability of default.
Third, apply trading multiple screens (PE, PB, EV/EBITDA, etc.) to find out potential value stocks. One can apply such a screen within a sector or an industry. One can also look at the stocks trading below median historical valuation based on its long-term trading multiples. These set of cheap stocks may have a lot of stocks which are potential ‘value traps’.

Fourth, apply a quality filter on the universe of the cheap stocks to separate potential winners from classic value traps. We use economic moat and current financial strength as two pillars to measure quality, where Quality = f (economic moat, financial strength).
Financial strength measures a firm’s profitability, stability, and improvement in operating efficiency. F-score is one of the most reliable ways to measure the current financial strength of a business.

Measuring economic moat
The most popular quantitative measure for economic moat is EVA or EVA momentum, but I propose here, three easy to understand financial metrics.
Free cash flow generation: Is the firm generating sustainable free cash flow over the full business cycle? Check FCF and its variants.
Return on investments: Is the firm able to generate substantial long term return on investments?
Margin analysis: Is the firm able to increase its margin or maintain high margin over the long term? Check gross margin, EBITDA margin, operating margin, net margin, etc.

Cheap stocks with a high composite quality score are more likely to be the true value stocks, while the rest of them are likely to be classic ‘value traps’.

Fifth and the final step is to invest in high-quality value stocks and enjoy your time. Do once in a year health check-up of your portfolio stocks to see whether your stocks still clear quality as well as valuation test. Take necessary action by holding on to those which clears the test, get rid of those which fail the test and replace them with new entrants.

The writer is chairperson (Finance), School of Business Management, NMIMS, Mumbai

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