Avoiding the Potential Pitfalls of Value Investing

So, you just found a stock trading at five times its annual earnings. It looks really cheap, but is it a good investment? Are there other factors that are contributing to its anemic valuation?

These are important questions that must be answered before you place your hard-earned cash on the line. Understanding a few of the factors that tend to contribute to low price / earnings multiples can help reveal the handful of true opportunities that exist amongst a sea of bad investments. The following are a few of the most common factors that contribute to low price / earnings multiples:

Earnings Boosted by Abnormal Spikes in Business Activity

Stock prices are based largely on expectations for future earnings. As a result, events that may have resulted in abnormally strong earnings in recent quarters are typically discounted by investors. They recognize that future earnings are unlikely to be as strong, and accordingly, adjust the price of the stock to reflect a normalized earnings picture. These abnormal spikes in business activity and earnings often result from the receipt of particularly large contracts, or short-term spikes in demand due to extraordinary product shortages. For example, during the ice storm that gripped Eastern Canada several years ago, there was a temporary short-term surge in demand for utility poles. This demand resulted in a major spike in earnings of utility pole manufacturers like Stella-Jones (SJ:TSX). Of course, demand soon subsided, and the companies’ earnings returned to more traditional levels. Similarly, abnormal non-recurring spikes in earnings can result from extraordinary gains resulting from the sale of assets, such as investments, subsidiary companies, or capital assets, or from the forgiveness of debt.

Taxes

Many young companies accumulate tax losses in their early years of operations as they build their business and work towards profitability. In their first few years of profitability, these companies typically use their accumulated tax losses to offset their income tax expenses, thereby allowing them to report higher earnings. However, analysts are sophisticated enough to realize that the company will likely have to pay taxes in upcoming fiscal years, and that the company’s earnings growth will be tempered by the tax expense. As a result, they will typically discount the company’s present market valuation, often considerably.

Type of Business

Companies that are perceived to operate in risky industries or markets, or that are dependant upon cyclical commodity markets, tend to be attributed low price / earnings multiples. This is due to the fact that analysts and investors hate uncertainty. If a company’s future earnings streams are at all in question, the market will discount its stock price to a valuation level that it feels more comfortable with based on very conservative future expectations. Oil & gas producers, which are subject to the cyclical fluctuations in oil and natural gas prices, are currently trading at below average price / cash flow multiples due to the investment community’s concerns that energy commodity prices will not be sustained at current levels over the longer term.

Share Structure Dilution

One of the most frequent contributors to low market valuations is share structure. Companies that have a low p/e multiple may have a considerable level of dilutive factors such as outstanding (unexercised) stock options and/or warrants, or a significant amount of convertible debt. This is particularly true if they are exercisable or convertible at a price close to or less than the current market price since the likelihood of the issuance of a greater number of shares in the future, thereby reducing earnings as calculated on a per share basis. In cases where there are substantial potential dilutive factors, investors will significantly discount the company’s stock price to reflect the future issuance of shares and the resulting impact on earnings per share and the firm’s price / earnings multiple. The share prices of companies with multiple share classes also tend to trade at a discount to their peers. This is especially true if one class of shares, typically those held exclusively or primarily by management, have multiple voting rights.

Legal Disputes

Stock prices are also often discounted to take into account the perceived additional risk resulting from outstanding legal disputes or environmental litigation.

Grant Robertson, B.B.A.

Disclaimer: The author is not a registered investment advisor. Accordingly, this article is presented for educational and information purposes only. Those seeking specific investment advice should consult a registered investment advisor. You are urged to consult your investment advisor before embarking on any new investment strategy as the strategies depicted in this article may not be suitable for all investors. The author does NOT hold a position in the companies mentioned herein.