Value investing involves investing in shares that are trading below their intrinsic-value. This disconnect between price and value could have arisen for a range of reasons. From global factors weighing negatively on investor sentiment, to the sector that this share operates in falling out of favour. The market can often price such short-term headwinds of a business far into the future. As a result, the share price falls and the resultant disconnect in the company’s valuation is then created.
Many investors spot this and take advantage of the good prices on offer, knowing that over-time, pressures will ease, earnings will recover and markets will come back to their senses. If this happens, great returns can be made.
However, value-investing is not always as simple as this as several shares that screen cheap, can stay cheap and even look cheaper as there could be fundamental reasons as to why they are priced punitively by the market. Not all shares that screen as being valuable actually offer value.
Before classifying a share as a value-share simply because it is trading below its intrinsic value, I would suggest taking these three broad considerations into account:
Deteriorating performance metrics
A continued trend of performance metrics or KPIs of a business deteriorating and the pace of this decline might raise questions around the future and long-term sustainability of the operations. Declining or slowing sales volumes, price reductions or the inability to push through price increases as well as rising operational costs within the company’s underlying business units are some of the more simplistic metrics to look at.
At a more detailed level, one might need to monitor specific metrics that are more suitable to look at for the industry that this business operates in. As an example, some of the KPIs to monitor if you are looking at a listed property share would be the trend on vacancy levels, renewal rates on new leases, escalation rates, tenant arrears and the average lease term. This would obviously be very different to the KPIs one should look at when investing in bank shares – the trend on credit loss ratios, price to book and return on equity are probably some of the metrics to keep an eye out for in this space.
A trend of deteriorating performance metrics as well as a grim outlook for the business going forward are causes for concern and may keep the share price down and potentially even lower. These factors should be taken into account as they may deter you from investing in the share or might inform your decision as to the appropriate price to pay to take these risks into account.
Deteriorating financial position
A business may be screening as a value share and may even be performing resiliently from an operational perspective, however the share price may be depressed due to the debt-burden of the business.
Before investing in the share, it might be worthwhile understanding the magnitude of the debt as well as the agreement that the company has with its debt-providers (usually banks). These agreements usually have specific covenant levels that the company must manage the debt in relation to. If one of the covenants are breached, the business may be forced into a corner of having to sell some of their “crown jewel” assets in order to restore the financial position of the company as per the agreement with the bank. Even if covenants are in tact and the path to de-gearing the balance sheet is fairly clear, the business could look like a completely different animal post de-gearing, which could materially change its investment case.
Longer-term industry challenges
Examples would be certain regulatory pressures or disruption within the industry that the business operates. These challenges can often place long-term overhangs on share prices. These overhangs can remain for several years despite resilience of the business from an operational point of view. As a result, a share can screen as having value but unless these overhangs are cleared or the market takes the view that the impact of these developments will be muted, they can remain cheap for a very long time.
There are several other factors that one could look at when determining “value”. The 3 highlighted in this article serve as a few broad and common considerations that the average investor can look into when examining a particular share.
In summary, not all shares that screen cheap are necessarily value-shares. There are specific macro and micro considerations that require varying levels of attention, depending on the specifics of the company being analysed. When looked at closely, these considerations could have an impact on your perception of a stock being “valuable” and as a result, may inform your decision to whether invest or not.
Preston Narainsamy is portfolio manager at Nedbank Private Wealth.