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

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.

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.

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.

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

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.

Latest Updates

Planning

Does your will qualify for the discretionary testamentary trust exemption?

Treasury has confirmed the exemption many families were hoping for. But buried in the fine print are two conditions that could leave some wills on the wrong side of the exemption, despite years of careful planning. 

Lithium's latest drop and what it means for ASX investors

Lithium's latest sell-off has punished ASX miners as prices remain hostage to shifting expectations. The key challenge is navigating a market prone to extreme volatility despite a strong case for the long-term demand outlook.

Investment strategies

CGT reform and fund turnover: who really feels the impact?

The implications of CGT reform are far and wide. As the 50% discount gives way to inflation indexation, turnover and return profiles may become critical drivers of after-tax performance. Some strategies face a far greater hit. 

Superannuation

Super was built for a very different Australia

Our retirement system was built around assumptions that no longer hold. Lower homeownership, longer lifespans and changing expectations are exposing cracks that policymakers and super funds need to address. 

Retirement

Retirement in reality - 4 months in

Many people spend years planning financially for retirement but little time preparing for what comes next. Four months in, here are the surprising lessons i've learnt on finding purpose, social connection and healthy habits. 

Investment strategies

After the Budget, Australia needs its own definition of quality

As tax reforms reshape investment incentives, investors should rethink what quality investing means in the uniquely concentrated Australian market, where traditional frameworks may not translate as effectively.

Datacenters are the new shale oil

Why are tech giants pouring billions into datacentres when the economics look questionable? The most dangerous words in investing may be: "everyone else is doing it". Today's AI boom has striking parallels with the shale bust.

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.