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

How to minimise tax with a will

Inheritance tax implications in Australia may surprise some, as poor estate planning without proper wills or trusts can lead to costly tax bills and delays for beneficiaries.

Testamentary trusts post-budget: Estate planning, tax reform and the ‘death tax’ debate

Proposed Budget changes to taxation are casting new uncertainty over testamentary trusts, prompting closer scrutiny of estate planning structures and the real implications of reforms still taking shape.

Meg on SMSFs: The CGT changes don’t impact super but what about Div 296 tax decisions?

New CGT rules could tip the scales in the super vs non-super debate. For those facing the Division 296 tax, the case for withdrawing has gotten more complex. A "comparison rate" tool may help assess decisions.

High quality businesses are on sale

Beneath the dominance of the ASX's largest stocks, much of the market has been left behind. High-quality companies are now trading at levels rarely seen, offering opportunities for investors willing to look deeper.

The strange effect of the 30% minimum capital gains tax

The 30% minimum tax on capital gains sits at the heart of the budget's proposed reforms. Yet the mechanics reveal anomalies that introduce unexpected distortions that raise questions about its design.

Welcome to Firstlinks Edition 667 with weekend update

The downfall of the giant and three lessons for investors.

  • 18 June 2026

Latest Updates

Latest from Morningstar

Ranking three common retirement strategies

The defining challenge of retirement isn't just about building wealth, it's about converting your lifetime savings into sustainable income. A holistic understanding of different strategies can improve long-term outcomes.

Economy

Was life really better in the good old days?

Are we worse off than previous generations? Lately, there seems to be a heightened level of angst that economic conditions are getting harder and that the two-party political system (and maybe democracy too) is failing voters.

Retirement

Australia has saved $4.5 trillion for retirement. Here's what matters more

Most Australians approaching retirement can tell you the exact dollar value of their super account. But success depends on more than a sizeable balance. Here's four key questions to ask yourself at the start of the financial year. 

Who gains in an AI-supercharged economy?

AI is already reshaping the economy, but companies building transformative technologies rarely capture the greatest long-term value. Instead, those benefits accrue to the users. We may well see this pattern reproduced. 

Taxation

Div 296's million-dollar reset worth $25,000

The 'cost base reset' for the new super tax is being sold as protection for pre-July gains. A worked example shows $1M of protection is worth about $25,000, and the real deadline has not passed.

Latest from Morningstar

The forecasting fix that Wall Street missed

Asking whether markets are overpriced may be the wrong question. New research suggests that traditional valuation metrics used to forecast returns may have been misread. Here are five takeaways for investors.

Investment strategies

Should a fund manager invest their own money differently?

Investors often like the idea that fund managers should invest client money exactly as they invest their own. But reality is more complicated. Unique circumstances make a different approach rational and, at times, beneficial.

Sponsors

Alliances

© 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.