Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 217

Five ways to avoid the 'value trap'

Investors with a predisposition to high conviction value investing often need value to be combined with an element of growth. Let's call it 'growth-value'. Our approach is not to look for 'cigar butts' but we do seek turnaround or under-researched ideas where the profits and growth are likely to continue.

Finding a 'value trap' investment is easy, but finding growth-value in an investment is hard. Everyone loves a bargain but it is important to look deep below the surface.

Looking beyond the value trap

A value trap is a company whose shares look cheap because they are trading at low multiples of earnings, cash flow or book value. For example, a low price to earnings (P/E) ratio or low value to earnings (or EV/EBITDA) ratio may be caused by a good reason, making the company a potential value trap.

Mistakes can be minimised by considering:

1. Consistent ROE and ROA

Management is key to any small company but it is especially vital when looking for growth-value. In our view, return on equity (ROE) provides a mechanism to measure management's track record delivering growth using the money shareholders have provided to the company. Value traps might have delivered strong ROE numerous years ago but a value-growth business will have consistent, and at a minimum, double digit ROE.

Should a company have debt, return on assets (ROA) needs to be taken into consideration. ROA accounts for the effectiveness of the company using that debt. Essentially, this provides a score of management's ability to generate returns across all sources of funding, both debt and equity. Different industries have differing levels of what is considered a healthy amount of debt so looking for consistency rather than volatility in an ROA figure is key.

ROE and ROA are two vital checks that provide a level of confidence around how efficiently management's ideas are being executed.

2. Balance sheet safety

For unloved small companies with debt, look at the interest cover ratio (EBIT relative to interest payments) as a proxy for business health. How many years' worth of interest payments can the current earnings sustain? Anything less than a multiple of two would be a concern and ideally this should be a lot higher.

The ratio of short-term receivables to payables is also a factor to consider. Regardless of the industry, consistency in this ratio indicates good management of working capital.

3. More than the basic valuation metrics

It is easy to get distracted and focus solely on a low P/E or EV/EBITDA and assume this translates to a high margin of safety. On their own these metrics tell nothing about growth prospects. In finding value-growth, the obvious growth factors such as revenue and EPS growth are looked for but also for EBITDA margin growth, free cash to enterprise valuation yield and the historical consistency of EBITDA to cash conversion. Together these provide a better understanding of the true margin of safety. It is a good sign if all these factors are inversely related to a low P/E or EV/EBITDA. If that is not the case then the company is probably on a low P/E or EV/EBITDA for a very good reason: it is a value trap.

We have made errors along the way by mistaking value traps for value-growth.

Investing is about maximising winners and minimising losers. Despite the perceived idea of minimal losses in value investing you still have to weigh up the likelihood of easily exiting an investment and the opportunity cost of that capital.

We like to think we are constantly learning from our mistakes, and the following two points have refined our investment approach.

4. Do not ignore industry thematics

We are fundamentally stock pickers, meaning our analysis is bottom up rather than looking at top down or macro and industry events and their potential impact on stock valuations. Regardless, it is a mistake to ignore the current and future industry environment in which a particular business operates. We have seen the speed and scale of technological disruption that is already impacting many industries. If tailwinds exist then growth is a lot easier to obtain, if headwinds are present then conviction on management's ability to adapt is needed.

5. Have a timeframe and stick to it

Always think about your opportunity cost of capital. Progress for small companies can take much longer than expected. Before making any value investment, have a timeframe in place. Within that timeframe, if benchmarks are not hit or are not explained in a logical manner, then it is time to reassess the investment.

To summarise, stick to what is known, look below the surface to assess business growth and management track record and always remember the opportunity cost of the invested dollar. Watch the investment rule that: "You don’t have to make money back the same way you lost it."

 

Robert Miller is a Portfolio Manager at NAOS Asset Management Limited. This article has been prepared for general information purposes only. It does not consider the circumstances of any individual and must not be construed as investment advice.

 

  •   31 August 2017
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

WAAAX and an extraordinary disconnect

Sebastian Evans: hanging on until the market catches up

Is value investing dead?

banner

Most viewed in recent weeks

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

The retirement scorecard: how many of these questions can you answer?

From the maths of retirement, estimating spending and picking the right asset allocation to survive a poor decade, here are the questions every retiree – current or future – should be able to answer for themselves.

Division 296: the initial moves to make before the windows close

What if the best superannuation strategy isn't about earning more, but acting before your options disappear? Several overlooked planning windows are narrowing, with consequences that can last for decades.

Testamentary trusts: Treasury has picked the wrong reading

A decades-old estate planning tool has survived one tax crackdown only to be caught by another. The surprise isn't who the reform is targeting, but who could end up paying the price for drafting choices made years ago.

Higher yields are creating opportunities in global bonds

Bond markets are adjusting to a new reality, but not in the ways investors expect. With markets repricing and capital competing for attention, investors may need to rethink where resilience and opportunity lie. 

Will investors be better or worse off under new housing tax changes?

Housing tax reforms have sparked warnings of market turmoil and promises of greater fairness. But after modelling nearly two decades of property data, the results suggest winners and losers may not be who many investors expect.

Latest Updates

Superannuation

Superannuation’s structural failings

Politicians are fighting over access to super, but they may be arguing about the wrong thing. The system’s three fundamental flaws have been hiding in plain sight for decades, costing Australians far more than they realise.

Planning

The great wealth transfer myth

Why do some families preserve wealth for generations while others struggle to? As the great wealth transfer unfolds, the determining factor is often not the structure of the estate, but the preparation of those who will inherit it.

Investment strategies

What comes after bank hybrids?

For years, bank hybrids have been a cornerstone of portfolio income. With tens of billions of dollars now disappearing from the market, investors face a critical question: what comes next, and are the obvious replacements enough?

Investment insights from the US

What happens when knowledge becomes a commodity? The latest themes emerging from the US tech sector suggest AI could reshape company moats, disrupt incumbents and create winners and losers in unexpected places.

Investing

Can Berkshire thrive without Buffett?

Warren Buffett's departure marks the end of an era. But the more important question for investors is whether Berkshire's culture, discipline and capital allocation framework can survive without the man who built them.

Retirement

The Bengen 4% Rule: Lost in translation

For years, retirees have been told to focus on withdrawal rates. But the real question is far simpler: how many dollars can you safely spend? The answer may be very different from what conventional retirement wisdom suggests.

Interest rates

Super low interest rates came with side effects

For more than a decade, investors lived through an era of near-zero interest rates. With bond yields now surging, it's worth asking whether cheap money solved economic problems, or introduced a much larger set of risks.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.