Trying to figure out what is a value stock and what is not a value stock is probably one of the biggest challenges every value investor has to deal with. You can spend your entire life reading Benjamin Graham and Warren Buffett (Trades, Portfolio)'s work, but you will never have a perfect road map to find the ideal investment.
It is not that these investors have never revealed the secrets to finding perfect value investments. It is the fact that the perfect investment does not exist. There is no set formula one can use to find an undervalued security with guaranteed profits. That's the unfortunate truth.
Even Buffett, who has had so much success throughout his career, has never been able to follow a road map. All he has been able to do is try and improve the odds of succeeding. He has done this by trying to stay within his circle of competence and only acting when he is sure that the investment opportunity is something he understands and the company is trading at an attractive valuation.
The big mistake
One big mistake value investors often make is focusing purely on companies with low valuations.
Anyone can screen the stock market for equities trading at discounted multiples. If it were that easy to find undervalued equities, everyone would be a great investor. But it is not that easy. Finding cheap stocks requires far more effort than just screening the market for stocks trading at a discounted price-earnings or price-book ratio.
In fact, using this method without giving any consideration to other factors could lead to substantial losses.
Red flags for value investors
Equity markets are quite efficient, and more often than not, cheap stocks are cheap for a reason. There are a couple of red flags investors should always try to avoid. Avoiding companies with these qualities will not always lead to success, but as I noted above, without a roadmap, all investors can do is try and improve their odds of success in the market.
One of the first factors that can indicate a stock is a value trap rather than a value opportunity is debt. A high level of debt can be a sign that the business is struggling to earn a profit. Even if it is profitable, debt can act as a stranglehold around a company's neck. It can cause a company to skimp on capital spending, which will hurt growth in the long-term. High levels of borrowing can also expose a corporation to rising interest rates. Companies can maintain elevated levels of borrowing for extended periods, but the tower of cards can quickly unravel, and more often than not, investors can be caught by surprise.
Another factor to watch out for is cash flow. This has caught me out on several occasions. Companies can use accounting trickery to improve their income statements, but it is far harder to manipulate cash flows. A company can appear to be profitable, but if cash is flowing out the door, in reality, it is only getting smaller. Sooner or later, it will have to find more cash to cover outflows, which could mean issuing more stock.
Another red flag investors should watch out for is the classic "do something" acquisition. Companies that are struggling to grow organically often go on acquisition sprees to try and drive earnings growth. This can be a sign that the business is not investing enough in itself or management has run out of ideas. Even if the company has excess cash, one of the best ways to improve shareholder value is to return cash to investors rather than spending the money on acquisitions, which may not produce results.
These are just some red flags investors might want to keep an eye out for when evaluating potential investments.
