Asked on 27 Mar 2019
Hello maybe I can share some tips here which I would try to avoid it!
I think one common pitfall is not really understanding how the business or industry actually works, so you may not be able to spot certain trends which may show overvaluation or undervaluation. Since value investing is about spotting stocks which the market isn't correctly pricing, a lack of understanding about the business could lead you to make the wrong judgements about how the stock is being valued.
2. Wrong Conclusions about High or Low Multiples
One of the ways to spot if a stock is over or undervalued is to compare the stock's P/E ratio with the rest of the industry. This method is intuitive and very effective at times. However, a low or a high P/E does not always mean that they are valued wrongly. High or low ratios could be caused by firm specific traits which may not be shared by their competitors. For example, a firm's share prices may fall because of a major or lawsuit or loss of a key customer, but it could also arise because the firm may have secured certain key contracts or just had an earnings call that they had a strong year. So before an investment is made, it would be good to find out there are other issues at hand.
Other than digging deeper into specific multiples like the P/E Ratio, you can also compared different multiples such as P/B ratio, PEG, P/FCF multiples etc with other industry players to validate your conclusion.
3. Too Short a Time Frame
Value investing is built on the premise that the market will eventually value the stock correctly, allowing you to make a profit off you spotting a more accurate valuation of the stock. However, the time frame for this to happen can actually be longer than expected, and there could be many reasons for this. For example, market sentiments, cyclical industries, lack of information could cause the market to react to the intrinsic value of a stock more slowly. So it would be good to wait it out longer, since value investing usually requires investors to be invested in the long term.
Hey Anon! Value investing is akin to shopping for good deals at a market. With the same logic, you want to buying stocks at a deep discount to what you believe they should be selling at- their intrinsic price.
I am sure you heard of the saying: "Buy Low, Sell High". There is therefore no point in "buying low" if the market never agrees with your sentiment on the stock. This is why as Isaac pointed out, a value investor could be looking at a undeterminable long horizon to get his returns back on his chosen stock.
Moreover, as value stocks are usually neglected underpublicized small cap companies, these firms can be heavily subjected to changes in the market situation. Recessions or big changes by conglomerates in the industry could heavily underpin the future of the company, or in the worst case, put these companies out of business even before the market recognises their inefficiently priced stocks.