Do your homework and minimise risks Taking Stock
WHEN investing for the long run, it is important to find undervalued securities that have enough potential to earn long-term capital returns.
But there’s one inherent danger: the risk of investing in a company that is cheap for good reason – a “value trap”.
To avoid this, it can help to apply a simple checklist.
ý Consider supply and demand dynamics
Awareness of the environment in which a company operates is critical.
What is the probability of an increase in the supply of a company’s product or service blunting its competitive edge – or at worst, putting it out of business?
In some cases, this is relatively simple.
For example, iron ore prices will go down when there is more iron ore in the market than required.
But the analysis may also be more nuanced.
Consider, for example, the growth in online retail, which has in some markets resulted in retailers requiring less floor space.
The result is an oversupply of retail space, which puts pressure on the price of retail property.
ý Do business with people you trust
This helps you to avoid management teams who have the propensity to make materially poor capital allocation decisions or who have been unethical in the past. ý Too much debt is deadly Elevated debt levels pose a significant risk to the stability of a business and increase the probability of permanent capital loss.
Banks, for example, rely on highly leveraged balance sheets to make economic returns.
While many investors automatically assume big banking names are stable, it is important to remember that banks such as Deutsche Bank, Morgan Stanley and Royal Bank of Scotland would be out of business were it not for government intervention.
ý Identify the impact of economic cycles
It is important to distinguish between cash flows that can be attributed to management skill and an economic competitive advantage, and those arising from cyclical macro tailwinds – which are temporary.
The South African construction cycle leading up to the 2010 Fifa World Cup serves as a good illustration.
In October 2007, the combined market value of the four largest construction companies in South Africa was R77.9-billion. At end June 2017, this figure stood at R18.3-billion.
This shows why it is imperative to have a full understanding of a company’s operations before investing. Getting it right
These steps can help you minimise the risks of falling prey to value traps.
But to truly invest successfully, make sure to do your homework on each individual security, assessing every buying opportunity on its merits and underlying fundamentals.