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

Indexation implications – key changes to 2026/27 super thresholds

Stay on top of the latest changes to superannuation rates and thresholds for 2026, including increases to transfer balance cap, concessional contributions cap, and non-concessional contributions cap.

The refinery problem: A different kind of energy crisis in 2026

The Strait of Hormuz closure due to US-Iran conflict severely disrupted global energy supply chains. While various emergency measures mitigated the crude impact, the refined product market faces unprecedented stress.

3 ways to defuse intergenerational anger

With the upcoming budget increasingly likely to include bold proposals to alter the tax code I’ve outlined three incremental steps with fewer unintended consequences.

The missing 30%: how LIC returns are understated, and why it matters

The perceived underperformance of LICs compared to ETFs is due to existing comparison data excluding crucial information, highlighting the need for proper assessment and transparent reporting.

Little‑known government scheme can help retirees tap into $3 trillion of housing wealth

The Home Equity Access Scheme in Australia allows older homeowners to tap into their home equity for retirement income, yet remains underused due to lack of awareness and its perceived complexity.

Welcome to Firstlinks Edition 655 with weekend update

Many investors are on edge as geopolitical turmoil continues to impact markets, often leading to short-sighted actions. These are the three quotes that I’ve relied on during periods of volatility.

  • 26 March 2026

Latest Updates

Retirement

2 billion reasons to fix retirement income

A proposal to address Australia's 'stranded balances' in retirement by requiring super funds to transition members to pension phase at 65, boosting retirement income and reframing super as a source of income.

Investment strategies

Not much alpha left in this bet

Google redefined advertising with its innovative business model, but its dominance is now under siege from AI competitors and shifting market dynamics.

Five simple reasons why Australian cash rates are highest

Australians are suffering the highest cash rates amongst their rich country peers for five simple reasons, including outdated inflation targeting and undisciplined monetary and fiscal policies.

Investment strategies

Spending big on AI: So where’s the proof it’s working?

Business leaders must reassess AI's return on investment using new frameworks that reflect productivity, capability shifts and long-term value creation.

Economy

Double down on renewables?

Global volatility has sharpened Australia's focus on energy security. Calls for domestic fuel production clash with renewable energy goals, sparking a debate on balancing traditional and sustainable energy sources effectively.

Investment strategies

Private Credit headwinds move onshore

It’s been a volatile couple of months in markets with the ongoing conflict in Iran. For Australian private credit investors, however, large exposures to real estate lending could mean the worst is yet to come.

Property

Five reasons unlisted commercial property is an attractive allocation in uncertain times

Cromwell takes a look at replacement cost as a practical lens on relative value in commercial property. When build-new costs rise faster than asset pricing, the gap can create opportunities in well-located existing assets.

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.