Value Traps – How to avoid them and why cheap stocks do not always make good investments

The objective of investing is to buy low and sell high. Often the best time to buy low is after a stock market crash like the one we witnessed in March. However, just because a stock is trading at a lower price than it has in the past, does not necessarily imply it is cheap.

Value Traps
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Valuation ratios can be misleading, and if a stock is not as cheap as it appears, the price may never recover. Seemingly cheap stocks can also remain cheap for a long time. In this article we discuss value traps and what you can do as an investor to avoid them.

What is a value trap?

Value Traps Definition
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If you believe a stock is cheap, you believe its value is higher than its current market price. This implies that you believe the market is wrong and you are right. If it turns out that you were right, the stock price should appreciate. Sometimes however, it turns out that the market was right, and you were wrong. This is a value trap.

As the name implies, a value trap is a situation that leads investors to believe a stock is trading on a low valuation, when in fact it is not. Value traps usually result in one of two scenarios; either future earnings disappoint, or the value of assets on the balance sheet is adjusted lower.

Value Investor / Stock Market
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Value investing is among the most highly regarded and successful investment strategies. But if you want to be a successful value investor you must be able to identify a potential value trap. This means differentiating between undervalued stocks and stocks that are cheap for a reason.

Very often the outcome of a value trap will depend on how many other investors have fallen for the same mistake. As shareholders realize their mistake, they will begin to sell the stock. The more shareholders find themselves in the same boat, the more the stock price will fall.

Common value traps

Common Value Traps
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Initially, a stock that is in fact a value trap will often appear attractive based on one of the following four valuation metrics:

Low trailing PE ratio

Chart / Calculator
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One of the most common investing myths is the idea that a stock is cheap if it is trading on a low price to earnings ratio. You can certainly compare a stock’s current PE ratio to its historical range, or to its peer’s PE ratios, to get a rough idea of how the market is valuing the stock. But a relatively low PE ratio only tells you the market is placing less value on the stock. It doesn’t tell you about the future.

Let’s say a stock is trading at $100 and recently reported annual earnings per share of $10. The PE ratio, or price multiple, is therefore 10. If the historical average PE ratio for this stock is 15, you might assume it will rise to 15 again in the near future. Investors will often assume that the price will appreciate to about $150 to put the stock back on a 15 PE.

But the PE ratio will also be 15 if earnings decline to $6.66 and the stock price stays at $100. And, if the market expects earnings to continue declining, the price multiple might stay at 10, which would mean the stock price declines to $66. A price earnings ratio doesn’t tell you about future earnings and growth. The stock price will only appreciate if the price is low relative to probable or actual future earnings.

Low forward PE ratio

Analyzing Charts
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A forward price multiple, or PE ratio, is calculated using expected future earnings rather than historical earnings. In practice, the average analyst EPS estimate for the next 12 months is used. This gives a better indication of the stock’s valuation, provided the estimated earnings are reasonably accurate.

This is better than using historical earnings, until analysts overestimate earnings. Typically, analysts underestimate earnings early in a business cycle, and then overestimate earnings towards the end of the cycle. If analysts begin adjusting their forecasts lower, the forward PE will rise, and the stock will no longer appear as cheap.

High dividend yield

Dividend Payments
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A stock’s dividend yield is useful when comparing it to other investments like bonds or property. When interest rates are low, investors seek out stocks with high dividend yields to generate income. Companies also use their dividend yield as a way to attract long term investors. But, like anything in the world of investing, when something seems too good to be true, it usually is. Buying stocks based on dividend yield alone can result in finding yourself in a value trap.

To pay dividends, companies need to generate reliable cash flow. If a company is paying a high percentage of its profits as a dividend, it may not be able to cover unforeseen expenditure. If cash flows are spent on dividends rather than reinvested in the company, revenue may eventually fall. Furthermore, if an attractive dividend yield attracts investors, a company’s share price will rise. For the company to maintain the dividend yield, dividend payments will have to increase along with the stock.

The problem with a dividend value trap is that eventually the company will have to cut the dividend. Investors looking for yield will then abandon the stock, and the price will fall. The typical result is that investors looking for an extra 5 percent in yield end up losing 50% or more when the stock price collapses.

Low price-to-book ratio

Accounting / Price-to-Book Ratio
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Well known value investors like Warren Buffett often evaluate a stock price by comparing it to the stock’s book value per share. Unlike valuation ratios based on a company’s earnings, the book value considers the value of a company’s assets. If a company is trading at a discount to the value of its assets, shareholders can make a profit by liquidating the company and selling off the assets. For this reason, investors often foresee limited downside when a company is trading close to its book value.

However, the concept of book value can be misleading for a number of reasons. Firstly, the book value of an asset is an accounting term and doesn’t always represent the value that can be realized. Secondly, impairments and write-downs of balance sheet assets will usually result in the book value of a company falling. If that happens, the price to book ratio will rise, and the stock price will often fall too.

Finally, the book value, or net asset value of a company is only of relevance if liquidation is a possibility. Sometimes there are controlling shareholders holding the investment for strategic reasons. These shareholders may have no intention of selling assets and may not be concerned with the share price either. Sometimes a low stock price may suit controlling shareholders keen to make an offer to minorities.

Why do share prices sometimes stay low despite appearing cheap?

Stock Market Analysts
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Even if a seemingly low valuation is not misleading, a stock’s price can remain depressed for other reasons. For a stock price to rise, the stock must attract new investors, and investors must be prepared to pay higher prices. Without a catalyst to attract new buying, the stock price will remain depressed.

Some industries and sectors are cyclical. Stocks trading at low valuations will often remain depressed until there is evidence that the cycle has turned. The mining and construction sectors are good examples of this – stocks in these sectors often remain undervalued for years until the cycle turns.

If a company’s business model is under pressure, its stock price may remain in a downtrend until it transitions to a more compelling business model. Most traditional retail stores are now in this position, as they struggle to compete against competition from e-commerce companies. Retailers can pivot into ecommerce, or they can differentiate themselves in other ways. But unless they find a new way to compete, there is no reason for their stock prices to recover, regardless of how cheap they may appear.

Negative Sentiment
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On a similar note, the sentiment surrounding a sector can also remain negative for long periods of time. When this happens investors often ignore the entire sector regardless of how attractive a specific stock’s valuation or fundamentals may be.

Management and corporate governance also affect the market’s attitude toward a company. If investors don’t trust a company’s management team, or if they lose confidence in management, the stock price can remain depressed until changes are made. If the board is not in a position to replace a company’s leadership, there is no reason to believe a stock will recover.

Warning signs for a potential value trap

Warning Signs / Value Traps
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There are lots of different reasons for a stock that appears cheap to in fact be a value trap. There is no single factor to look out for, and there is no value trap indicator to refer to either. However, the following warning signs are worth keeping an eye out for:

Pricing power

Analyzing Financial Figures
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If a company loses its competitive edge it will struggle to maintain its profit margins. Once margins begin to fall, they continue falling until the company can regain its edge. Sometimes margins will be sacrificed to maintain market share – but this can still hurt profitability. Unless there is a good reason to believe the company can defend its margins, earnings are unlikely to recover.

Expensive growth

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When interest rates are low, or stock valuations are high, companies often fund growth with cheap capital. A company can use cheap capital to offer incentives and discounts to new customers. This can generate impressive growth rates that may not be sustainable. A stock that appears cheap relative to historical growth rates may be a value trap if it won’t be able to access cheap capital again.

Acquisitive growth

Trading Graph / Chart
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Very often companies that grow by buying smaller companies become value traps when the acquisitions stop. Typically, the company will overpay for the acquisitions, and when those assets fail to deliver on the amount paid, a series of write-downs follows. The stock appears cheap relative to both its historical growth and its book value – but earnings growth and the value of its assets continue to fall.

Corporate governance

Businessman / Corporate Governance
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If a company is performing poorly and corporate governance is problematic, a recovery may be a long way away. This can occur when management is dishonest or delusional, when they have too much power or when big egos are involved. If it appears that the management teams are putting themselves before shareholders, they probably are.

How to avoid value traps

Avoiding Value Traps / Stock Trader / Charts
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At the stock picking level, the only way to avoid a value trap is by doing your homework. Valuation is just one aspect of what makes a good investment, and the cheapest stocks don’t necessarily make the best investments. It’s therefore worth considering other aspects of an investment too. Market sentiment is an important factor behind price action, but also needs to be considered along with other factors. Sentiment is an important component of LEHNER INVESTMENTS Data Intelligence Fund – but the strategy also considers other factors.

Considering a stock from the point of view of behavioral finance will help you understand the biases that may affect the stock price in the future. Market timing is not always as easy as it seems and trying to time the market is often what causes people to find themselves falling for a value trap. You should also continuously revisit any assumptions you have about a stock.

Successful Trader
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At the portfolio level, diversification and asset allocation will reduce the impact of an investment that turns out to be a value trap. Mutual funds and passive investing funds like ETFs are usually sufficiently diversified to avoid value traps. By keeping the position size of individual stock holdings low, the impact of a value trap is minimized.

Conclusion: Avoiding value traps

Long term investing usually pays off if you can buy a quality stock at a good price and you are patient. But, if you invest in a value trap, your patience won’t pay off. Even if you don’t lose money, you would be better off with that capital invested elsewhere. To avoid investing in a value trap, your fundamental analysis should also consider what factors and catalysts will cause the stock price to rise in the future. If a stock is cheap for a good reason, it may stay cheap until something changes.

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