For rookie value investors, it’s easy to get lured in by the siren song of value traps disguised as severely undervalued stocks that trade at multiples well below that of historical averages.
Just because a stock appears cheap, with low price-to-earnings (P/E), price-to-sales (P/S), or price-to-book (P/B) ratios, doesn’t mean that it’s undervalued. There may be a few puffs left in such widely discarded “cigar butt” stocks, but there’s also a risk that you’ll get burned if the business behind the stock is facing insurmountable headwinds.
If there are fundamental flaws with the underlying business, there’s no reason why a “cheap” stock can’t get much cheaper. A stock’s multiple can quickly expand if earnings fall behind, so one shouldn’t pay too much merit to low P/E multiples of the shares of a distressed company that’s in danger of facing pressure on the top or bottom line.
Consider IGM Financial (TSX:IGM) and Alaris Royalty (TSX:AD), two cheap-looking stocks that are enticing to the average value investor because of their massive dividends, which are currently at 6% and 7.5%, respectively.
While the handsome dividends are on stable footing, investors must be wary of potential downside risk, which could end up dwarfing what one will stand to receive in dividends.
Sadly, IGM is on the wrong side of a secular trend.
The rise of do-it-yourself (DIY) investing is a trend that’s gained traction with millennials, and over time, I see technology as an accelerator to the trend. Unfortunately for IGM, which derives a considerable amount of its revenues off the sale of pricey actively managed mutual funds, I see margins and profitability on the downtrend, even though management has made moves to become more competitive with the new era of asset management.
IGM is not shying away from technology, and its gravitation towards higher-net-worth clients bodes well for margins over the intermediate term. Unfortunately, neither endeavour, I believe, will prevent significant margin compression over the next five years and beyond, as the big banks look to better cater to the growing appetite for DIY investors.
IGM may be on the right track, but being a non-bank wealth and asset manager, I believe, is a considerable disadvantage given the marketing spend to win over clientele that’s more easily reachable for wealth management services (passive or active) by their existing personal bank.
Alaris has had a terrific year with shares up 30% year to date. For those unfamiliar with the company, it provides capital to “old-school” easy-to-understand businesses (primarily in the U.S. market) across various industries in exchange for equity, a royalty stream, or a blend of the two.
The massive 7.5% yield is the main attraction for income investors, and although management has a track record of ensuring proper due diligence prior to making any investment, Alaris has had its fair share of fumbles in the past. And when you’ve got a relatively concentrated portfolio of investments, all it really takes are a few bad apples to spoil the bunch.
The stock has lost over half of its value between the peak in 2013 and the trough in 2018 thanks in part to some less-than-stellar partnerships that halted distribution payments. Alaris has continued to keep its dividend intact, even during the peak of its issues in 2018, but I am wary of investing in the name, because it’d only be prudent to bet on the basket if one has a full understanding of all of Alaris’s partners and investments, along with their ability to sustain royalty payments over a prolonged period of time.
While I don’t see Alaris as a garden-variety value trap, I think there are too many royalty streams to keep track of, which could catch many uninformed income investors by surprise. If it becomes difficult to collect royalties from a few partners at a given point in time, the dividend could fall easily under pressure.
Sure, the 7.5% yield is attractive, and the stock is dirt-cheap at 11.7 times next year’s expected earnings, but I’d only invest in the name if you’re willing to do the extra homework and analyze each one of the names in the Alaris basket. Personally, I’m not a fan of management, given the firm’s past fumbles, and won’t be betting on the name with my TFSA.