Beware of value traps that look attractive but costly in the end


Every investor wants to find a company that’s a great bargain, but sometimes, not all awesome bargains are what they seem. FILE PHOTO | POOL

June 2, is the National Fish and Chip Day. Please allow me to share a fun fact about fish: did you know that fish are actually very smart and can learn?

Fish will avoid situations they know to cause them pain, and will seek out experiences with rewards. Will often work together to increase their chances of catching something to eat.

Even inviting Octopuses to hunt jointly. Some fish remember musical tunes. Others like the archer fish can recognise human faces and even tell them apart.

Even more remarkably, they can still identify people with faces turned away from them. But like all animals, they still fall prey.

Let me explain. Fish eat bait and worms are known to be good fishing bait. They attract fish universally and are the most visually appealing to hungry fish.

They can be relied on to consistently catch dozens of species of fish with relative ease - at least in a fresh water body.

How’s this devotion to ichthyology analogous to the markets?

Watching a market that’s down 23 percent if you follow the Nairobi All Share Index (NASI) and spotting a price-to-earnings (P/E) ratio of five percent (60 percent below its nine-year average), one may be tempted to “take the bait.”

You see every investor wants to find a company that’s a great bargain, but sometimes, not all awesome bargains are what they seem.

Value traps often spot low multiples in metrics like the P/E ratios, price-to-cash flow or price-to-book value. And like the bait worm, a value trap looks attractive on the surface but can cost you a lot.

But there are ways to avoid them if you’re careful. Try comparing the company to the sector. If the competition is outpacing the stock you’re considering by a great deal, you already know why that stock is cheap.

Look up the company’s history. If you see inconsistent returns and a history of poor management, avoid them. Also, check if you find some good institutional holding. Mutual funds can more easily move a stock than retail investors.

Moreover, if a company has more financial leverage, that could be a dangerous value trap. A meaningful way to identify this is by looking at the debt ratio of the company.

This is calculated with total liabilities divided by the total assets of the company.

The key is to not get “baited.” I know investors want to buy low and sell high. But do not let your over-religiousness overshadow your investing behaviour and decision-making.

Like Warren Buffet put it so wisely, “it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

As relates to today’s “Fish and Chip” day, the best way to observe it is to take a cane, a length of fishing line with a 24-inch monofilament leader, tie a number six hook on it, tie a split shot 12 inches above the hook and hook an earthworm to it. Throw it in the water and sit back like a villain waiting for a bite.

The writer is the managing director of Canaan Capital