The easy part of investing in a stock is the numbers. Is the stock cheap or expensive – relative to the market, the sector, and its history? How do the financials look? What’s the cash flow like? These are all crucial to the stock analysis process.
But for a lot of people, that’s where the analysis ends, which is not good.
If you’re only looking at the numbers when you are trying to understand a stock, chances of losing a lot of money on a bad investment is a lot higher.
These are the three questions beyond the numbers in high-risk, high-return emerging and frontier markets, as well as the most boring and stable stocks in dull, developed markets.
1. Are you getting caught up in the moment?
In late 2014, the United States and Cuba – an island 177 kilometres off the coast of Florida that (according to some) posed a grave and existential threat to American sovereignty – re-opened relations, after a 54-year freeze.
Eager stock investors raced to invest in Cuba even though it had (and has) no stock market.
Instead, a conveniently named closed-end fund with the ticker symbol CUBA had a ready answer.
CUBA invests in the shares of companies that stand to benefit from economic opening and growth in Cuba. With Cuba all over the news, in late 2014 investors piled into the lightly traded CUBA fund, doubling its share price in two weeks.
The premium of the shares (relative to the underlying value of the portfolio) peaked at an incredible 71%, meaning that investors were paying $1.71 (RM7) for every $1 of assets.
Needless to say, neither the earnings or the forecast earnings of the stocks in CUBA doubled during those two weeks.
Cuba had, and has, a very long and difficult path in front of it.
The excitement of renewed relations with the US was more than public relations, but contrary to what the CUBA share price suggested, it had very little immediate relevance to the financial performance of companies that stood to benefit (eventually) from the opening of Cuba.
And what has happened since? CUBA shares are down 43% from their peak of euphoria in late 2014. Cuba (the country) is still opening and will continue do so for another generation or two.
Cuba and CUBA were a great story, but a terrible investment.
2. If it’s government-owned, who gets the cash?
Russia’s Gazprom is the world’s largest gas company, based on total reserves (of an impossible-to-comprehend 36.4 trillion cubic meters). It supplies one-third of the natural gas consumed in Europe.
Back in Soviet times, Gazprom was big enough to be an entire government on its own. It has supported entire remote cities in Siberia and sponsored football teams.
That’s all fine for Gazprom and for Russia. But it’s not great for minority investors, who are the common people.
You see, Gazprom, which is controlled by the Russian government, accounts for around 8% of Russia’s GDP, and a large chunk of Russian government revenues.
When the Kremlin needs money to plug a budget deficit, it turns to Gazprom.
The company is a geopolitical hammer that is used to threaten or cajole its customers from Europe to China (twist a few taps, and no more gas for Ukraine, say) – as it is a gas company.
And, of course, Gazprom is also a convenient source of cash to top up well-placed ministers’ retirement plans.
(Persistent rumours suggest that Russian President Vladimir Putin is one of the richest people in the world, a remarkable feat given his US$136,000 annual salary.)
Investors get excited about asset-rich Gazprom without asking the critical question: Who benefits if the company makes mountains of money?
In the case of Gazprom, lots of people benefit but minority shareholders rarely do. The shares are down 86% from their all-time high in 2008.
There are a lot of reasons for that bad performance, many of which lead to the fact that the company is managed like a big ATM for the Russian government and friends.
3. If a stock is very, very cheap, what’s the trigger?
Gazprom shares are very cheap on a valuation basis. It trades at a P/E (price-to-earnings ratio) of around four. Other gas companies trade at multiples that are three-10 times higher.
Gazprom shares are also a fraction of the price of global oil producers. ExxonMobil shares, for example, trade at a P/E of 24. Chinese producer China Petroleum and Chemical Corporation trades at a P/E of 11.
But the problem is, Gazprom shares has always been cheap.
Since May 2008, when the stock reached an all-time high at a market capitalisation of US$366 billion – compared to US$50 billion today.
And in recent years the only time that the shares have not been cheap was when earnings collapsed (which is the worst reason for a P/E ratio to rise).
Value traps are stocks that seem cheap on a valuation basis (if you’re using the price-to-earnings ratio or a similar measure), but in reality aren’t that cheap at all or else remain “cheap” indefinitely.
And Gazprom shares have been cheap for as long as anyone can remember.
What could change that?
A value trap can be stopped and become an attractive, under-valued investment if there’s a trigger for change.
A change in management, a big change in the industry, higher commodity prices or a regulatory change. All these things can turn a value trap into a great investment.
However, the Russian stock market has been cheap forever too – so in context, Gazprom shares aren’t all that cheap. And is there a catalyst?
Perhaps… but generations of Russian stock analysts think things are really changing in Russia, in a way that would permanently improve the valuations of its stock market.
And it hasn’t happened yet. Holding those perma-cheap stocks represents a steep opportunity cost.
Therefore, when you’re looking to buy a cheap stock, ask yourself, why is it cheap? Will there be a reason for that stock’s valuation and price to get higher?
Of course, these questions are only a start. Investing isn’t easy. It takes hard work, research and experience.
This article first appeared in thenewsavvy.com
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