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.


 

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

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

Latest Updates

Investing

Designing a life, with money to spare

Are you living your life by default or by design? It strikes me that many people are doing the former and living according to others’ expectations of them, leading to poor choices including with their finances.

Investment strategies

A closer look at defensive assets for turbulent times

After the recent market slump, it's a good time to brush up on the defensive asset classes – what they are, why hold them, and how they can both deliver on your goals and increase the reliability of your desired outcomes.

Financial planning

Are lifetime income streams the answer or just the easy way out?

Lately, there's been a push by Government for lifetime income streams as a solution to retirement income challenges. We run the numbers on these products to see whether they deliver on what they promise.

Shares

Is it time to buy the Big Four banks?

The stellar run of the major ASX banks last year left many investors scratching their heads. After a recent share price pullback, has value emerged in these banks, or is it best to steer clear of them?

Investment strategies

The useful role that subordinated debt can play in your portfolio

If you’re struggling to replace the hybrid exposure in your portfolio, you’re not alone. Subordinated debt is an option, and here is a guide on what it is and how it can fit into your investment mix.

Shares

Europe is back and small caps there offer significant opportunities

Trump’s moves on tariffs, defence, and Ukraine, have awoken European Governments after a decade of lethargy. European small cap manager, Alantra Asset Management, says it could herald a new era for the continent.

Shares

Lessons from the rise and fall of founder-led companies

Founder-led companies often attract investors due to leaders' personal stakes and long-term vision. But founder presence alone does not guarantee success, and the challenge is to identify which ones will succeed in the long term.

Sponsors

Alliances

© 2025 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.