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When I first started value investing, I lost a lot of money. It was quite easy to find cheap stocks and I was mystified why no one else is jumping on these opportunities. Turns out, there were reasons! Some of these companies went bankrupt while some others went nowhere at all.

Value investing is a powerful strategy, but it’s not as simple as just buying stocks that look cheap. Many new investors take a plunge with enthusiasm, only to find themselves making costly mistakes that erode their returns. Now older and wiser, I tend to make less of these mistakes, although you can never eliminate these completely. Understanding these common pitfalls can save you from unnecessary losses and put you on the path to long-term success.

Let’s start with the most common.
 

1. Chasing Low P/E or P/B Ratios Without Context

Why Cheap Doesn’t Always Mean Undervalued

A low price-to-earnings (P/E) ratio might seem like a bargain, but there’s often a reason a stock is trading at a discount. Many new investors fall into the trap of buying stocks solely based on low multiples without considering the company’s fundamentals, industry trends, or potential risks.

Consider this for a minute. Most of these ratios are trailing ratios, meaning they show you the earnings that have already happened. The estimate of the forward P/E may actually be very fuzzy. Most analysts do not agree on their estimates. If you sit down to make your own estimates, you will soon realize that changing a few assumptions here and there can actually make a big change in the estimates.

So what do you do? Lean towards conservatism.

How to Avoid This Mistake

• Focus on intrinsic value, not just P/E ratios. Intrinsic values can be estimated based on multiples, but there are many other ways to estimate the intrinsic value – some are more conservative than others.
• Analyze the company’s earnings quality and sustainability. Do you expect the company to be able to maintain their margins or even expand them going forward? Are there competitors breathing down their necks? Do they have expiring patents?
• Compare valuation metrics across competitors and industry standards. An airline company selling for 6 times earnings may not be cheap given that airlines are notorious for their low margins. A semiconductor stock selling at 25 times earnings may actually be cheap if its order pipeline is all filled for the next 5 years.

The flip side is also true. There are stocks that have seen significant earnings drop, but that may be temporary and the market recognizes that. Even though the stock went down, it did not go down too much, and the stock may actually show a very high P/E ratio. Is this over-valuation? It may not be.
 

2. Ignoring the Quality of the Business

A Bad Business at a Low Price Is Still a Bad Investment

Some companies trade at seemingly attractive valuations because their business models are flawed. Weak competitive positioning, declining revenues, or poor management can make even the cheapest stock a terrible investment. Would you invest in a newspaper stock today? How about a budget airline that nickels and dimes you for every little convenience and operates at the thinnest of margins.

How to Avoid This Mistake

• Prioritize businesses with durable competitive advantages. Buffett is fond of insisting for a moat. This competitive advantage is what makes a revenue stream sustainable.
• Assess management’s capital allocation skills. Do they shoot for the moon every time? It is great to have a few exploratory projects that take the company forward, but a disciplined management will emphasize diverse cash flows and will not bet it all on unproven ideas.
• Look for strong balance sheets and stable cash flows.
   

3. Falling for Value Traps

When a Stock Is Cheap for a Reason

A value trap is a stock that looks undervalued based on traditional metrics but never recovers because its business is in permanent decline. Many new investors get stuck holding onto these stocks, hoping for a turnaround that never comes. Some of these stocks may become a cigar-butt stock – you may be able to get one final puff out of it, but you should not expect it.

How to Avoid This Mistake

• Identify catalysts for value realization. Generally, during your due diligence, if you think there is value to be realized, you should have some ideas on how they could be realized. Then think of the chances of those possibilities working out in your favor. For example, if a possible scenario is that if the company gets a regulatory approval for a new product, then the revenues will rise significantly. How likely is the approval? How far along is the company in the approval process? What do the initial assessments say?
• Avoid industries facing secular decline. I come back to the newspaper example. Many of these businesses have reinvented themselves for the digital age by offering online editions. But a large number of papers do not have any rationale to continue to exist.
• Monitor earnings trends and management execution. The best horse can lose with a bad jockey at the helm.
   

4. Overlooking Hidden Risks in Financial Statements

Not All Numbers Are Created Equal

Many new value investors take financial statements at face value without digging deeper. Accounting tricks, off-balance-sheet liabilities, or unsustainable profit margins can make a company appear healthier than it is. Many companies shift revenue between quarters to manage expectations. You can avoid some of these risks by looking at financial statements spanning multiple periods and then examining the trends.

How to Avoid This Mistake

• Read the footnotes in financial statements. Is there a significant increase in customer returns? Are their lawsuits in progress that can adversely affect the business.
• Watch for aggressive revenue recognition or excessive debt. If the revenue is rising and the finished goods inventory is rising faster, there may be something fishy going on. Perhaps the company is recognizing revenue earlier than they are allowed. Are they raising dividends by taking on more debt (because the earnings do not support this)?
• Use owner’s earnings instead of reported net income.
   

5. Failing to Demand a Sufficient Margin of Safety

Even Great Companies Can Be Bad Investments at the Wrong Price

Benjamin Graham emphasized the importance of a margin of safety—buying stocks at a price significantly below their intrinsic value. Many new investors overpay, assuming that quality alone will ensure good returns. Some investors may choose to ignore the lack of margin of safety, arguing that the growth rate overrides the high valuation. I do like the Growth at a Reasonable Price argument, but I do not advocate for Growth at Any Price mentality that was the hallmark of the internet craze.

How to Avoid This Mistake

• Always calculate intrinsic value conservatively. I would recommend calculating the liquidation value even if the company may be doing quite well, just to set a benchmark for the most conservative valuation you can muster.
• Avoid over-optimistic growth assumptions. No one knows what the future holds. Competition does not shout they are coming.
• Require a wide margin of safety, especially in uncertain markets. Bad things happen all the time. Worse, you will make mistakes, and sometimes big mistakes. A wide margin of safety will protect you with unknowns and unknowable unknowns.
   

6. Getting Impatient and Selling Too Soon

Value Investing Rewards Patience

Many investors get discouraged when a stock doesn’t immediately rise after they buy it. Selling too early out of impatience or fear means missing out on the long-term compounding potential of value stocks. In fact, what is more likely to happen after you purchase the stock, is that the stock will decline even more. As a value investor, you are looking for good values, but you have no guarantee that you will find the absolute best time to buy the stock.

How to Avoid This Mistake

• Set clear investment theses and timelines. Write them down. When things get hairy, you may not think correctly. It is good to have written notes to reassure you.
• Ignore short-term price fluctuations. They do not reflect shift in values. Only the long term price movements do.
• Focus on business fundamentals rather than market noise. Most of the market noise has nothing to do with the stock or the company.
   

7. Over-Diversification or Under-Diversification

Too Many Stocks Can Dilute Returns, Too Few Can Increase Risk

Some new value investors spread their capital too thin, owning too many stocks and failing to concentrate on their best ideas. Others put all their money into just a handful of stocks, exposing themselves to excessive risk. I have talked about the importance of diversifying a lot, but there is a limit beyond which diversification does not gain you any more benefits and just dilutes your performance.

How to Avoid This Mistake

• Maintain a portfolio of 10-20 high-conviction positions. Any less, and you can be too concentrated in one name. Any more and you will not be able to keep up.
• Avoid diworsification—only buy stocks that meet strict criteria. You do not have to chase every opportunity.
• Balance sector and industry exposure wisely. I don’t see a point in buying multiple stocks from the same industry or sector. If the whole sector is undervalued, buy the best one. This will allow you to spread your investments across more industries/sectors without watering down individual positions.
   

8. Blindly Following Gurus Without Doing Your Own Research

Even the Best Investors Make Mistakes

Many new investors mimic high-profile fund managers without understanding their reasoning. Just because a well-known investor buys a stock doesn’t mean it’s a good fit for your portfolio. In fact, and I have argued this elsewhere, two different investors holding the same stocks in their portfolios bought at same prices may still show widely different returns. One may even be in profit while the other is losing money. This is because they have allocated their portfolios differently.

How to Avoid This Mistake

• Use guru purchases as a starting point, not a final decision. You don’t know why they are buying a stock. Perhaps the stock is a diversifier. For example, Gold is not something a value investor may think of buying, and its long term returns are not great, but a portfolio that contains gold and is rebalanced frequently, returns better than the same portfolio without gold in it.
• Analyze the stock independently before investing. You will be surprised when you find out that you disagreed with something, and you were right.
• Ensure the investment aligns with your strategy and risk tolerance. Investing is a process that needs to fit you. You may not be comfortable with the risk, for example, this may be your core portfolio, but for the guru this could be his or her “play money” portfolio. They might end up with a better return, but would it be worthwhile to you if you end up with sleepless nights wondering whether you will be able to afford your kids college in 5 years time?
   

Mastering Value Investing Requires Discipline

Avoiding these common mistakes won’t make you a successful value investor overnight, but it will help you sidestep unnecessary losses and develop a more disciplined, profitable approach. Stay patient, focus on intrinsic value, and remember that value investing is a long game. With time and experience you will get used to seeing red flags and avoiding them, without having to actively look for them. You will also adjust your expectations so you do not feel the need to chase every opportunity. The market will reward those who invest wisely and wait for opportunities to unfold.

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