On the face of it, the UK stock market appears to be cheap, residing as it is at one of the biggest discounts to other global markets ever. 
Given this fact, investors may expect that many of the constituents of the UK index also look cheap, and a simple screen of the stocks would suggest incredible value is on offer right now.
For example, within the FTSE 100 there are currently eight stocks yielding more than 8 per cent, 22 yielding more than 6 per cent and a huge 43 dishing out yields of more than 4 per cent to their shareholders.
Surely the fact that nearly half the FTSE 100 yields over 4 per cent must make it an incredible bargain?
We don’t believe so. In fact, we believe these are dangerous times for all investors, but value investors in particular.
Having waited for years to buy stocks at attractive valuations, value investors might be forgiven for thinking they can hear the sweet sound of opportunity in the stock market.
However, many of these stocks are, we believe, value traps, beckoning in the unwary. For numerous years and through many cycles, investors have always been caught out by such stocks.
As a result, there are some clear lessons to be learned from the past, and below are three such sure-fire ways investors can lose money on the stock market.
1. Pay too high a valuation and watch the stock de-rate
Over an investment cycle, you will see companies sporting all types of valuations as investors change their mind about their relative prospects. For example, let’s take a company with earnings per share (EPS) of 10p which the market thinks will grow rapidly in the future, and hence it values it on 20x those earnings, giving an expected share price of 200p (10p x 20).
However, the market later changes its mind about the growth prospects of this company and brings the price-to-earnings (P/E) multiple back to a market average of 14x. This would produce a share price of 140p (10p x 14), or a loss of 30% to those who had bought the stock at 200p.
Bear in mind all that has happened here is that investors have changed their minds about the growth prospects for the business; it has de-rated even though nothing fundamental has changed with regard to the underlying business.
2. Pay too high a multiple for a stock that sees both earnings and multiples decline
Continuing with the hypothetical example above, this time we assume the EPS declines by 20 per cent to 8p. This is likely to upset all investors, but growth investors in particular as they had paid a high multiple expecting growth to continue and are not happy to see declining earnings instead.
To show their annoyance they put the lower earnings on a lower multiple, say 12x, giving a share price of 96p (8p times 12) and a 52 per cent loss to the original investors.
3. Buy an expensive company with a weak balance sheet
Imagine the above combined with real, rather than perceived, earnings decline and you have one way to really lose money in the stock market. For example, if we take a company that has a market cap of £1bn and debt of £1bn, it has an enterprise value of £2bn.
The business produces £100m of earnings before interest and tax (EBIT) and therefore the stock is valued on 20x EV/EBIT (2000/100).
However, the market decides that 20x is just too high and the stock is de-rated to 15x. Therefore, the new enterprise value is calculated by multiplying the unchanged EBIT of £100m by the new lower multiple of 15x to give us £1.5bn.
Even though the debt level has stayed the same at £1bn, all the changes have come through the market cap, which has halved, and is very painful for shareholders.
Furthermore, if earnings go down by 10% and the multiple comes down from 15x to 13x. Yet again the debt remains unchanged and this time the market cap has fallen to £170m and the poor shareholder has lost 83% of his money. Ouch.
Ian Lance is manager of the TM RWC UK Equity Income fund. The views expressed above are his own and should not be taken as investment advice.