Beware of the "Value Trap"

Reaper

I mentioned this briefly in another thread but thought it worth a post of its own.

People often say they plan to buy a share because its price has fallen and they plan to profit from the bounce back. They may indeed be bargains but do not buy solely because the price has gone down. Some stocks go down and stay down, or fall further. To buy purely because the price has fallen is the "Value Trap".

Imagine a footballer is worth £5m on the transfer market but now he is on offer for £2m. He might be a bargain or it might be because he is injured and we are waiting for the doctor's verdict on whether he will ever play again.

A real world example (where I got my fingers burnt) is HMV. They sold books, games, CDs etc, all of which are increasingly bought on the Internet. So when their price went down it did not mean they were good value, and the share price went on going down. They may not even survive.

I can rabbit on about the dangers of historic dividend figures and the importance of dividend cover too if you want to hear more, but maybe that's enough for now.

King_Of_Bling

Reaper wrote: »

I can rabbit on about the dangers of historic dividend figures and the importance of dividend cover too if you want to hear more, but maybe that's enough for now.

YES, carry on.

Is it true that a PE ratio around 11 and yield of around 3~4% is good?

edinburgher

To buy purely because the price has fallen is the "Value Trap".

Yup - only buy companies that you believe have a decent future ahead of them!

Reaper

King_Of_Bling wrote: »

YES, carry on.

Is it true that a PE ratio around 11 and yield of around 3~4% is good?

OK, since you ask...

The first thing to realise is the PE may be incorrect. It is of course the price divided by the earnings.

Let's imagine the company issues a profit warning. The price will fall immediately but if the earnings figure being used is what was earnt over the last year the fall will make the PE apear to be a bargain. That's because the earnings are now going to be a lot less but the PE you are looking at is probably using the new price and the old earnings figures.

Now for the yield. That same company may have paid 3% dividends in the past. Now that the price has dropped the yield shoots up to 4%. However bearing in mind that profit warning it is likely that dividends will be cut too and you will not get the yield you expected. Be wary of any company paying a high dividend yield until you have checked out that it is likely to continue at that rate.

One way you can try to insure yourself against future falls in dividends is to look at the "dividend cover". This tells you how big a slice of their profits (after tax) went into paying the dividend. So for example a company with a dividend yield of 3 means they could afford to pay the dividend 3 times over if they wanted. However if the dividend cover is 1 that means all the profit they made went into paying out the dividend with nothing left over.

Don't let all this put you off buying shares. There are some quality companies going cheap, but I just don't want people to think if a share price has fallen it must automatically be cheap. It might still be over-priced.

If in doubt buy a fund instead and leave it to a fund manager to decide what to buy.

talexuser

Wise words for those newbies who think that just because a correction causes a dip that all values will recover from a downturn.

Fancy historically investing in Woolworths, Allied Carpets, Viyella, Pontins, Focus DIY, Habitat, Oddbins..?

Rollinghome

King_Of_Bling wrote: »

YES, carry on.

Is it true that a PE ratio around 11 and yield of around 3~4% is good?

Definitely. Or possibly bad. It depends entirely on the company.

Trading stocks can be fun but people really need to be a little realistic. The price of any share will depend on what buyers are willing to pay and what sellers are prepared to accept. The overwhelming majority of those buyers and sellers are likely to be professional traders running various funds with huge research resources.

If you do all your numbers and come to the conclusion that a share is a bargain then it may be possible you are right and the trader selling is wrong. But unfortunately it's more likely that you've just overlooked something the professionals know.

It's equally unfortunate that many amateur active traders have selective memory about their mistakes, especially those found on the internet.

Reaper

King_Of_Bling wrote: »

Is it true that a PE ratio around 11 and yield of around 3~4% is good?

Sorry, just realised I never actually answered your question.

If you think the world is headed for recession then you want a very low PE because you expect earnings to drop, so there is no absolute point at which it becomes cheap.

Yes I believe a P/E of 11 is below average historically, and there are plenty lower than that too. You can find figures from previous years to compare it with here, and it also shows average dividend cover.

If you prefer graphs here is one of the Dow Jones from Wikipedia:

Miss_money_2

I was wondering if someone can help me. I am interested in buying shares but have no idea where to start. I know what company I want to buy into but how do I go about it all???

I've had a look online etc but the information seems a little complex.

Tom_Pickering

Miss_money wrote: »

I was wondering if someone can help me. I am interested in buying shares but have no idea where to start. I know what company I want to buy into but how do I go about it all???

I've had a look online etc but the information seems a little complex.

I opened an account with Halifax share dealing. They charge £11.95 a deal, and there is no annual fee for holding the shares in their nominee account. Some companies charge this fee if you don't do enough trades or if your portfolio in below a certain value e.g. £5,000. Some folk use X-O.co.uk @ £5.95 a deal, but i can't comment as i don't use them. You might save a little on dealing charges, but you've got to be careful with the spread the company charges as this is one way low charge shock brokers can make their money back.

Miss_money_2

So Halifax do all the shares paperwork for you. I tell them what shares I want and they process it all?

experience08

Miss_money wrote: »

So Halifax do all the shares paperwork for you. I tell them what shares I want and they process it all?

Yes, just have enough money in your account to cover the share purchase and dealing charges. I use TD Waterhouse, and have quite a few shares in the account, so i don't even have to have the money in the account to buy (upto £25K)...i usually go T+5 which gives me a few extra days to fund the trade.