What is a Value Trap?
What is a value trap? The short answer: a value trap is a stock or other investment that seems to be undervalued on the market, making you want to buy because it looks cheap.
But don’t be misled. Cheap stocks don’t necessarily mean the company is a good investment. In fact, the price of the stock might never go back up. Below is a complete breakdown of a value trap and how you can avoid one.
- Value traps appear to have strong fundamentals. You find companies that look great and cheap on the surface but actually aren’t doing well.
- Value traps typically appear attractive because of a low price-to-earnings ratio and low price-to-book ratio.
- They often stem from accounting problems, peak earnings traps, and changing industries.
- Avoid value traps by carefully performing a fundamental analysis. Analyze the company, industry, and overall economy.
Value traps appear fundamentally sound.
Value traps pop up when you’re a value investor. You find companies that look great (aka have seemingly strong fundamentals) and cheap but actually aren’t doing well – it’s all an illusion.
Value investing is about finding companies that are priced BELOW what they are intrinsically worth. Basically, you want to find companies that have strong fundamentals but sell for less than what they’re worth. They aren’t exactly sexy companies but they are stable.
This investing approach is based on two principles:
- Find high-quality companies
- Buy them at bargain prices
You then sell these investments when their stock price matches the company’s actual value.
On the surface, value traps appear to be excellent opportunities. They are trading at low valuation metrics over time. They often look attractive based on the following four metrics:
- Low trailing PE ratio
- Low forward PE ratio
- High dividend yield
- Low price-to-book ratio
But the actual reason for these low metric values is that the company is struggling financially. They aren’t likely to grow and you won’t be able to turn a profit later on. These stocks are cheap for a good reason.
Here’s a good example of a value trap:
Rag Shops Inc. was once a company that sold fabric and craft supplies. The company had a low price-to-book ratio. Its stock price appeared cheap to investors. But under its low valuation metrics were serious problems:
- Management failed to communicate financials
- Lack of consistent profits
- No competitive advantage with stores such as Michael’s
In 2007, the company filed for bankruptcy, and investors were left with no profits. Rag Shops, as many retail stores are, was structurally challenged. It couldn’t adapt or overcome within the changing digital world.
Tip: Select value stocks in well-known, established industries. Some solid value companies include JPMorgan Chase and Bank of America Corporation.
Value traps stem for a number of reasons.
As stated above, value traps, just like true value investment opportunities, can have a low price-to-earnings ratio, high dividends, and low price-to-book value. But these numbers are there for a negative reason and companies are actually unable to generate revenue or profit growth.
Here are common reasons why value traps develop and why company numbers look attractive:
Just because a company shows strong cash flow and a low PE ratio doesn’t mean it couldn’t suddenly go bankrupt.
Hidden company flaws might exist. Management could be manipulating the numbers, making key financial data look better than it is. For example, management might report adjusted earnings, showing profits before specific costs or charges.
A low PE is also often caused by high future payment obligations such as high-interest debt or other liabilities.
PEAK EARNINGS TRAPS
A peak earnings trap happens when a highly cyclical company (e.g., automobile or steel manufacturers) peaks in its earnings cycle. The price-to-earnings ratios of the company will appear low during this time with high earnings. Cash is flooding in and the company’s stock price is low. For the value investor, these companies look attractive and undervalued.
But then the business cycle turns and earnings fall (typically within three years). When earnings fall to cyclical lows after the boom is over, the PE ratio shoots up. If you recall, value investors look for companies with a low PE ratio, not high.
Tip: Cyclical companies move between highs and lows, impacting the numbers. Consider avoiding cyclical stocks.
The market is always changing which can impact stock prices. For example, newspapers, though once a booming business, have now been largely replaced by digital publications.
Because of this, newspaper stocks would have seen a sharp drop in price. If you compared these prices to a newspaper company’s past net income 10-15 years ago, you might have assumed that its fundamentals were still strong.
But in actuality, the company was going under, its product largely irrelevant. Comparing stock prices with past company data was useless as historic profits couldn’t predict the future.
Value traps can be avoided with careful fundamental analysis.
No need to panic when it comes to potential value traps. Instead, do your homework. Fundamental analysis helps you recognize high-quality companies so you can buy them at bargain prices.
It involves analyzing three components: the company, the industry, and the economy.
At a micro-level, analyze the company of the stock you want to invest in. You want an overall picture of the company’s financial health (present and future).
You analyze quantitative factors including financial statements such as the balance sheet, income statement, and cash flow statements. Calculate important metrics including
- Working Capital Ratio = Current Assets / Current Liabilities
- Quick Ratio = Cash + Cash Equivalents + Current Equivalents + Short-Term Investments / Current Liabilities
- Earnings per Share = Net Profit / Total Number of Shares
- Price to Earnings Ratio = Current Stock Price / Earnings per Share
- Debt-to-Equity Ratio = Total Liabilities / Total Shareholders’ Equity
- Return on Equity = Net Income / Shareholder’s Equity
- Price-to-Book = Market Capitalization / Book Value of Equity
Also look at qualitative factors such as the business model, the company’s leadership, organizational structure, and competitive advantage.
Part of a fundamental analysis is better understanding the company’s industry and its health. You review a company’s competitors, their market share, and the industry overall.
It helps you understand opportunities, weaknesses, and how your company compares to other companies in the industry.
Review the economy as a whole to discover any macroeconomic factors that could impact a company’s growth potential and performance.
Look at factors like the health of the overall economy, which sectors are performing well, supply and demand, etc. Review elements such as GDP (Gross Domestic Product), interest rates, inflation, and employment data
According to Preston Athey, “The best way to avoid a value trap is to ask the obvious question; ‘if this stock is so cheap, why is it cheap?’ The cheaper it is the more the market is telling you there is something wrong. If that’s the case and you’re still intrigued, you better dig really deep.”
Get started with fundamental analysis
Buy-and-hold is the name of the game with value investing. It requires patience to generate wealth over time. But if you purchase value traps, your patience will be for nothing. You will either lose money in the end or your money could have been better invested elsewhere.
This is why valuation and fundamental analysis is so crucial when reviewing company stocks to invest in.