Don't get duped: Why cheap ASX shares can still rip you off

Have you ever eyed an absolute bargain at a clothing store? Marked down 60% off, too good to miss, right? At least that's what you thought until it started falling apart after the first few wears. In hindsight, a higher quality product at a higher price might have made a better purchase.

The analogy sheds light on a common pitfall in investing. Somewhere along the line the term value investing was hijacked, leading many investors to think ASX shares with a low price-to-earnings (P/E) ratio were cheap and presented value.

Coveted British fund manager, CEO, and founder of Fundsmith, Terry Smith, discusses this grave misconception in his book Investing for Growth. The issue with buying shares (ASX or otherwise) based on a trailing earnings multiple is that it gives no credence to the future — whether good or bad.

When a bargain turns into a bin fire

Much like the above-mentioned clothing example, cheap does not equate to value in the investment arena. In his book, Smith puts it in this eloquent way:

A stock may have a low valuation but an even lower intrinsic value. Buying such a stock is not a recipe for investment success.

Typically, there is a good reason why a company is carrying a low earnings multiple. The market is forward-looking — so if there is an expectation of lower earnings in the future, the price will be discounted in anticipation of this.

To borrow a thoughtful table from Smith — and translate it with 'cheap' ASX shares — below is a collection of so-called value shares from late 2017:

At the time, these companies may have appeared lowly valued. At 22 earnings, G8 Education operated in a steady industry and was throwing off cash — not a bad proposition.

Fast forward five years, and suddenly G8's earnings per share (EPS) has plunged 79%. At today's earnings, the price paid back on 1 December 2017 would equate to a 100 times multiple… now that looks expensive!

High-quality ASX shares don't need to be cheap

You might now be wondering, 'Well, what's the alternative? What is a truly 'cheap' ASX share?'. As pointed out in Investing for Growth, the trick is to find those companies which could offer more value in the future than is being valued in the present.

Back to our shopping analogies — imagine a pair of boots that are marked at full price, going for around $500. At face value, that may seem expensive, considering other boots are available at a third of the price.

However, you do some research and find out the 'expensive' boots come with lifetime free repair and complimentary polish every two years. At that moment, you realise the more premium-valued pair offer a far better deal in the long run.

Searching for high-quality ASX shares is a similar experience.

How many times do you hear a company trading on an earnings multiple above 50 as 'good value'… hardly ever. Yet, as shown in the table below, some of the best-performing ASX investments over the past five years were trading on such lofty valuations.

As Smith states in his book, "The level of valuation which may represent good value at which to buy shares in a high-quality company may surprise you."

The overarching lesson here is: A growing company can still be valuable at high prices, while a shrinking company can be expensive at nearly any price. Pick the better boots now and avoid the disappointment of cheap boots later.