Low P/E
When people begin investing, one of the first valuation metrics that people are taught is the price to earnings ratio. The common rule of the thumb is that the lower the ratio is for a stock, the better value it is, but a bit of work can quickly prove that this is a recipe for financial disaster.
P/E ratios are based on just one year of earnings, and there are a plethora of ways for it to be unnaturally large in a single year. Often new investors aren’t very versed in the language of accounting, so they simply see a profit and fail to look into it. Even worse, there is sometimes blatant manipulation of the numbers that cons amateur investors out of their hard earned money. When the P/E ratio starts getting below 5, the market generally believes that the business is doomed, and 90% of the time they are right. When dealing in this part of the market you have to be either incredibly lucky or incredibly prudent. Returns can’t be generated with anything else.
To avoid this simple trap, I believe that new investors should simply not look at this part of the universe until they are versed in accounting. There will be plenty of opportunities passed up, but they will also survive far more disasters by simply not being there. Investing isn’t a sprint, and this type of stock will always be around, just act like it isn’t until you are ready.
Low P/B
The second metric that most value investors are taught is the price to book ratio. A shallow knowledge of this one can be far more fatal to the investor than the above. When the Western world focused on manufacturing, there was a lot of genuine bargains simply by sorting through this ratio, but with changing economies means changing investment styles.
The quality of assets are everything, and unless you are the CEO, it is often hard to know what they are. For example, in a mining business there may be a lot of equity, but upon further analysis you discover that most of it is in equipment. If it is old, it likely has no real resale value and is more of a liability as it will have to be replaced which will take the form of debt, something you don’t want. There is a lot of legwork that must be undertaken to properly work out the value of an asset, and often may be for less than the business is stating.
One way to get closer to a bona fide bargain using this metric is if there is no debt, the business has been consistently producing cash and cash makes up most of the equity. If this criteria can be met, chances are there is a very good opportunity. These are the businesses that I seek out as it greatly reduces the downside while leaving an immense upside still available.
Cyclical businesses
Often when amateurs buy into cyclical businesses, they are at the end of the bull cycle (perhaps I should make this into an indicator). The reason for this is that at this point, earnings growth is up, debt is down and everything appears to be perfect. However, as these businesses are nearly always in commodities, once the price goes up supply rushes to catch up. A simple lesson in economics 101 would allow most investors to miss these traps, but alas, the allure of profit far outweighs any rationality.
Cyclical businesses also generally tend to be risky for long term holdings, as there can rarely be a ‘niche’ producer of a commodity. Producers are simply price takers and are victims of the full brunt of capitalistic tendencies to trend towards concentration. The victor is simply the survivor of the downturn, and while the winner revels in a mass market share, it is incredibly hard to pick this, and many fail. I recommend refusing to play this game, instead focusing on businesses that don’t rely on the whims of a commodity unless you are ready to experience extreme volatility and believe you have an eventual winner. A rather hard game to play and one generally not leading to outsized profits, so may luck be ever in your favour...
Lack of patience
While this fault isn’t exactly a lack of analysis, it is a lack of emotional strength. Both are equally important when invested in any market. Value investors focus on the long run, and while this may be a hard pill for some to swallow, this timespan generally means above 1 year. If you aren’t ready to commit to time periods far beyond this, I highly recommend looking into a different investing strategy.
Perhaps the most potent benefit of patience is the utilisation of a deferred tax liability. Consider a trader who sells each day, he will have to pay an income tax in Australia that is around 40% of his profits, if he even manages to turn one. On the other hand, we have an investor who has held onto the one stock for 20 years. He hasn’t paid any tax on this one investment all that time, so his capital is constantly compounding without the traders donation to his government. If both people had the same annual return, the long term investor would end up with far more money than the trader. The lesson for this is even if you are a mediocre investor that simply tracks the market, you will likely outperform all the traders, even if they are earning a few extra percentage points a year.
The ability to hold onto positions is also a byproduct of one's conviction. If you are in the mindset that the investment is to be held for a decade, I can guarantee that there will be far more research involved, leading to a better decision.
While I can’t guarantee avoiding these traps will make you rich, they certainly help. Money is a finite resource, and every time you don’t waste it provides another opportunity to allocate it efficiently and grow your wealth. Sometimes in life the battles you don’t fight are more important than the ones you do, and in investing the same holds true.
Best of luck in your investing endeavours!
