There are two important scenarios that should make investors think twice before buying a particular share.
The first is where a share is trading at an excessive valuation as a result of huge share price gains without a comparable increase in earnings.
The second situation arises when a company appears to be trading at a cheap valuation but is facing an extended period of hardship. This scenario is sometimes referred to as a 'value trap'.
Both of these scenarios are quite common and it is important for investors to identify when this might be the case.
With that in mind, here are three shares that investors might be tempted to buy, but should probably keep on a watchlist instead:
NIB Holdings Limited (ASX: NHF)
NIB is one of my favourite shares on the ASX but the $2.5 billion private health insurer looks fully valued right now. The shares have been bid-up pretty strongly after a better-than-expected first-half result and this sees the shares trade at more than 22x earnings. Although NIB is enjoying a strong period of growth at the moment, the medium term outlook for the sector looks less promising as higher premiums are likely to result in higher customer churn and lapse rates.
Telstra Corporation Ltd (ASX: TLS)
Telstra's current grossed up dividend yield of 9.7% certainly looks attractive, but I'm not totally convinced that investors aren't being sucked into a 'value trap'. Unfortunately, the telco giant is struggling to find any earnings growth and this is forcing the company to payout more than 100% of its earnings to maintain its current dividend. This is clearly an unsustainable situation and I would be inclined to sit on the sidelines until Telstra can clearly identify a path back to positive earnings growth or a more sustainable dividend payout.
Costa Group Holdings Ltd (ASX: CGC)
The Costa Group share price has rallied around 30% over the past two months after the food grower and packer delivered a big profit upgrade in combination with a strong first-half result. While this was undoubtedly a welcome surprise for the market, I think it is important for investors to remember that Costa Group is still an agricultural company that is exposed to higher risks than many other companies on the ASX. With the shares currently trading on a forward price-to-earnings ratio of around 25, I don't believe investors buying shares today are being a offered large enough margin of safety to account for the potential risks the company faces.
