Value traps can ensnare even the best value investors. But in a recent piece for Canada’s Globe and Mail, Validea CEO John P. Reese offer some advice on how investors can limit the impact these traps have on their portfolios.
Reese says there is a key step investors should take to protect from value traps (that is, a stock that appear to be cheap at first glance but whose value proves to be a mirage): Use multiple valuation metrics. “Yes, using a single valuation metric can lead to outperformance over the long haul,” Reese says. “But for a given stock at a given time, a single valuation metric can be very misleading. For example, a company whose sales have been declining may still be squeezing more and more earnings out of those sales by delaying needed capital improvements or making some crafty accounting manoeuvres. In such cases, the company’s P/E ratio is likely to be artificially low, and its price-to-sales (P/S) ratio may be a better gauge of true value.”
Other times, companies can use dangerous amounts of debt that boost earnings and sales in the short term, but make for serious long-term headwinds that will detract from future earnings, Reese writes. In such cases, the EBIT/enterprise value metric can give a better sense of the stock’s true valuation.
“A stock doesn’t have to look cheap using every value metric – you simply aren’t going to find many technology companies with low P/B ratios – but it should look cheap using more than one,” Reese says. “By using multiple valuation metrics within your investment strategy, you make it less likely that you will walk into a value trap.”
Reese uses his Guru Strategies, each of which is based on the approach of a different investing great, to find stocks that impress using multiple valuation metrics. Among those he highlights: blue-collar staffing firm TrueBlue.
Tagged: John P. Reese, Validea, valuation metrics
from Validea's Guru Investor Blog http://ift.tt/1RRjjIw
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