10 Worrying Signs that Your Stock May be a Value Trap

Thursday, Feb 09 2012 by
10 Worrying Signs that Your Stock May be a Value Trap

Value Investing is all about identifying stocks with unidentified or underappreciated potential and waiting for that value to be realised over time. However, it's always worth remembering that some stocks are cheap for a reason. Of course, we all hope that the market will come to recognise what a bargain our latest investment was. But, every now and then, a price fall may lure you into every value-investor's nightmare - a false bargain, better known as a value trap. 

What is a Value Trap? 

A value trap is a company that appears cheap because of a large price fall, but which is actually still expensive relative to intrinsic value. In effect, it is masquerading as a value stock. It looks like a bargain price because it has come down so much but, despite the allure of a low price, a value trap's price is low for a good reason - unlike a true value stock, these companies are experiencing a fundamental change in their business prospects and could basically dying companies. As Warren Buffet said, “price is what you pay, value what you get".

Timothy Fidler of Ariel Focus suggests that there are two main types of value traps

  1. Earnings-driven value trap - This is where the mirage of a low price/earnings valuation vanishes as EPS evaporates over time - every time you think it looks "cheap" again, earnings fall further. This process is usually persistent and can last for years. More often than not, the misguided investment thesis is some variation of "They used to earn X, so if they could just get back to something near X, the stock would work well".
  2. Asset-based value trap - Also known as "cigar-butts", these types of stocks look exceptionally cheap in terms of asset valuation (e.g. the price/book ratio relative to current profitability). In some cases, the trap is simply that the reversion to the mean of unsustainably high profitability. However, Fidler suggest that the real danger comes from companies with opaque or ill-defined risks where the flawed investment thesis is "I know the risk is there, but I think it is already in the price or over-discounted".

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…

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6 Comments on this Article show/hide all

anahin 14th Feb '12 1 of 6

Most people often misunderstand "value" to mean cheap.

Value has nothing to do with the price of an item.
Value investing is not about buying cheap stocks but about buying stocks which are worth more than they are selling for - regardless of where they cost $1 or $1000 per share.

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SteMiS 30th Mar '12 2 of 6

It can't be as easy as this otherwise everyone would be a value investor (does anyone set out to buy stocks which are worth less than they are selling for?).

Value stocks are those which look cheap on the basis of assets or current earnings. Investors who buy stocks that are expected to grow earnings are growth/GARP/Blue sky/Recovery investors, depending on the situation. Alternatively you could be interested in dividends and be a (high) yield investor.

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MadDutch 1st Apr '12 3 of 6

Very good article, and one that I will want to return to in the future. But how to find it? 

Suggestion for Stockopedia; create a "best posts" folder, into which we can vote articles of long term interest like this one.

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Edward Croft 1st Apr '12 4 of 6

In reply to MadDutch, post #3

The easy way to find articles on this site is using search, which is very good on this site. If you search for 'value traps' its the top link. http://j.mp/HcWu90 .

Otherwise you can navigate to the popular posts on the Value Investing discussion page. http://j.mp/HCyXDz

We used to have an 'add favourite' link for specific articles. It's something we could add back in at some stage, but we've found that people tend to have their own bookmarking solutions for the entire web rather than for single websites so we aren't sure how much it would be used. Personally I use Instapaper (http://j.mp/HCzANw) rather than browser bookmarking as I can then read articles on my phone, kindle, laptop or anywhere.

Any ideas most welcome.

Blog: Follow @edcroft on Twitter
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Mark Carter 3rd Nov '15 5 of 6

"Chanos argues that growth by acquisition is a major sign of a value trap."

I think that this is a major thing to watch out for in AIM companies. You will often see rising earnings, giving if the feel of a growth company. The valuations can be uncharacteristically reasonable. BUT WATCH OUT. If that growth was by a series of equity fundings and acqusitions, I would suspect foul play.

"Many seasoned investors and sell-side analysts wait until a catalyst gets ready to hit the market"

That's a bit of a contentious point, I think. Bolton, and a few other managers, never worried about catalysts.

Finally, I like this little gem from Greenblatt: companies often run out of money before management runs out of turnaround plans.

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Fangorn 4th Nov '15 6 of 6

In reply to MadDutch, post #3

You could just bookmark it in your browser.

So in Google chrome, just click the "star" then decide where, in your bookmarks , you want to place it. Easy peesy. :)

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