A stock that appears to be cheap because the stock has been
trading at low multiples of earnings, cash flow or book value for an extended
time period. Stock traps attract investors who are looking for a bargain
because these stocks are inexpensive. The trap springs when investors buy into
the company at low prices and the stock never improves. Trading that occurs at
low multiples of earnings, cash flow or book value for long periods of time
might indicate that the company or the entire sector is in trouble, and that
stock prices may not move higher.
Companies, and even sectors, can be doomed,
because of situations such as the inability to survive competition, the
inability to generate substantial and consistent profits, the lack of new
products or earnings growth, or ineffective management. Often, a value trap
appears to be such a good deal that investors become confused when the stock
fails to perform. As with any investment decision, thorough research and
evaluation is recommended before investing in any company that appears cheap
when reviewing its relevant performance metrics.
How to avoid Value
Traps...
Of course, it's easy to say with hindsight that a
failed investment was a value-trap but are there any ways to flag this in
advance? Fundamentally, the key to avoiding value traps is doing your homework
and exercising caution when approaching enticing investment prospects.
It's crucial to be as precise as possible about intrinsic value through
fundamental bottom-up company analysis. The other issue is that it's important
to have an adequate margin of safety since this is the value investor's
buffer against errors in the intrinsic value calculation. However, beyond that,
there are some common fact-patterns that it's worth watching out for....
Few Signs that Your Stock May
be a Value Trap
1. Is the sector in long-term secular decline?
A company may simply be serving a market that no longer exists in
the way it used to. No matter how good the company, it will need a fair
wind behind it eventually and and if the sector itself is dying, it's likely to
be a huge battle to realize value. From a demand perspective, it's important to
distinguish between cyclical and secular declines. In the former case,
short-term demand will rebound with an improved economy. In the latter
case, demand is in long-term decline (e.g. due to societal and demographic
changes), which means that the remaining players are left to fight for a share of
an ever-decreasing pie.
2. Is the risk of
technological obsolescence high?
Technological progress can radically reshape an industry and its
product lines - this can have a major impact on the life cycle and
profitability of a firm .One might assume that a stock is cheap enough to
compensate for decreasing cash flow but, sometimes, cash flows hits a tipping
point and drops off faster than you expect.
3. Is the company’s business model fundamentally flawed?
Sometimes, a company may simply be serving a market that no longer
exists, or at a price-point that is no longer relevant, given competition
and/or new substitutes for the product.
4. Is there excessive debt on the books?
More often than not, financial leverage magnifies the pain of a
value trap. Limited or no financial leverage gives firms access to the the
most precious commodity of all - time! A company with no debt is unlikely to go
under, barring a major catastrophe (e.g. a massive legal settlement against
it). On the other hand, excessive leverage can destroy even a great company.
For a good margin of safety, the debt to equity ratio should be as low as
possible and interest cover should be comfortable
5. Is the accounting flawed or overly aggressive ?
It's best to stay away from companies where aggressive or dubious
accounting is employed. You should be “triply careful” whenever management
uses some metric that they define, rather than conventional metrics .
6. Are there excessive earnings-estimate revisions?
Analysts are quite lenient and usually revise their estimates
downward before earning releases to allow companies to beat their estimates.
Occasional missed earning estimates can provide an opportunity to buy on the
dip, but a pattern of missing earning estimates may mean that management are
struggling to forecast properly, with a knock-on effect for the analysts,
and/or that management doesn’t understand or are not willing to fix
problems.
7. Is competition escalating?
Be careful of companies facing increasingly stiff competition. Is
there a tendency for the industry to compete on price to squeeze
margins? If there are limited barriers to entry and a company is unable to
differentiate itself, then it's possible that the market structure has simply
moved against it - it may never recover the glory years of the past. One way to
test this is to compare the historic profit margin trend over the last 10
years. If the profit margins are decreasing, this may suggests the company is
unable to pass increasing costs onto its customers due to increased price
competition
8. Is the product a consumer fad?
Another sign of a possible value trap is a product that is subject
to consumer fashion or whims. Evolving consumer tastes and demand may mean that
the market for the product is just a short-term phenomenon
9. Are there any worrying corporate governance
noises?
It's worth checking for any history or noise that suggests
minority shareholders might be getting a raw deal .
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