Have you ever been in a situation where you found a stock that looks like a great bargain but later you realize that what looked like a great deal turned out to be a complete failure? Well, you are not alone. Investors often fall prey to something called value trap, when they go hunting for bargain.
These bargains may appear promising at first, but at the end of the day they are a big let-down for their investors which end up eroding their hard earned money.
In this post we will discuss what is a value trap? Characteristics of a value trap stock, and How to identify if you are holding a value trap stock?
What is a Value trap stock after all?
Contents
Value trap are those stocks that seem to appear to be trading at lower valuation, such as low P/E multiples cash flow or book value, giving a false image of being a great bargain opportunity. Such stocks attract investors looking for value stocks as they seen inexpensive relative to their earnings multiple.
Investors buy these stocks considering them great value stock but the trap springs out when the price of the company keeps declining for a long period of time.
Why people fall into the value trap?
One of the most common reasons are lack of in depth research, and even some psychological biases that most investors are not aware of. Half cooked knowledge can be dangerous, here are some of the most common reasons why people fall into value trap:
Low Price Stock:
One of the most common myths among investors is that they confuse price of the stock with value. This leads to a false opinion that if a stock has lower price, it means that it’s a bargain. There is no truth in such statement. Let me give you an example.
L&T finance Holdings (L&TFH) and Aditya Birla Capital (ABCap) are holding companies. At the time of writing this, L&TFH is trading at a price of ₹124 per share while ABCap is trading at a price of ₹97 per share.
Source: Screener.in
Investors who often confuse price with value will find that ABCap is far cheaper than L&TFH as its trading at lower price.
However, if you compare the P/E ratio of the stocks while L&TFH is trading at a P/E of 11.19 ABCap, on the other hand is trading at a P/E of 24.19, far more expensive compared to L&TFH.
What I am trying to show here is that price of the stock is not a good indicator of value, just because a stock is cheap does not mean that it is a good investment. The true value of the stock is determined by the earning ability of the stock.
Investors who focus solely on the price often fall victim of value trap, and end up losing their hard earned money.
“What is there to lose?” value trap:
The stock is already trading at ₹10, what is there to lose? How many times have you heard people say this? This is one of the most common value traps used by penny stock operators to lure investors into investing in poor stocks. This is how it works, you come across a stock trading at ₹10 and think it’s a lot safer than buying a ₹100 stock.
If there is anything that I have learned in the past 15 years of investment experience, it is this, whether a stock is ₹10 per share or ₹100 per share, if it goes to zero, you still lose everything.
The point is that a cheap, lousy stock is as poor investment as a lousy expensive stock. It does not matter at which price you buy, if it’s a poor stock, it is going to be a poor investment.
They think they can fish the Bottom:
Bottom fishing is a very popular pastime in the market, another value trap. The rationale behind investing in such stocks is that investor believes that the stock has fallen so much that there is hardly any downside from here and the stock is highly likely to move up from here.
Most investors live in this illusion where they think they know when the bottom of the stock has arrived. Trying to catch the bottom of a falling stock is like trying to catch a falling knife, grabbing a falling knife may result in nasty surprises because inevitably you grab it from the wrong side.
If you are really interested in buying such stocks, make sure that there is a sensible reason behind it, “the stock has gone down, it will go up now,” is not one of them.
Catching falling stock, thinking you are buying early at lower valuation could be a value trap. Keep buying more, and you get deeper into trouble making it harder to get out of, just like a quicksand, where you don’t realize how dangerous the situation is till it’s too late to get out of it.
But what makes a stock a value trap? Every stock has some common traits, because of which, they behave in a certain way and can be categorized. Even value traps have certain traits and characteristics, if you understand them, you can easily understand if a stock is already is or is going to become a value trap. What are those characteristics? Let us look at each of them:
Characteristics of a Value Trap:
Some of the most common characteristics of a value trap are given below:
Inconsistent or Declining Profit:
If you have read this a million times before elsewhere or on my blog, here it is me saying it again, every stock is a part ownership in a business, and the future returns of the stock depend on the earnings growth of the business, no exceptions.
Companies trading at lower valuation may look like a value buy, but if they have inconsistent or declining earnings, they might be a value trap. Since the growth of a stock depends on future prospects, poor and inconsistent earnings growth degrades the growth potential of the company and thus the stock might degrade even further no matter how low the valuation is.
Lack of growth Catalyst:
Companies need catalyst in order to keep growing. A catalyst is a factor or an event that favours growth of the company.
A catalyst could be anything, such as decline in raw material prices which can help company improve margins. New product launch that is gaining huge popularity. A Strong Brand name. Favourable Government policies that can boost growth etc.
If a company has no growth catalyst, there is a good chance that it is going to become a value trap in the near future.
There is one important point that you should remember, a company’s history should never be overlooked. Look at the past financial data of the company and find if the company had a growth catalyst in the past, and if that catalyst will be able to propel the company in the future as well.
Rising Operational cost:
In order to keep growing, every company needs to keep exploring different potential growth areas, and thus keep changing allocation of capital from one product or sector to another.
A company may have to invest in a new project, or pay off its debt, or even pay dividends. If a company is unable to align its capital allocation as per the needs of the business, it will result in poor return on capital, which will ultimately hurt the company’s fundamentals.
Poor Economics:
Warren Buffett once said “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact”
What Warren Buffett means to say here is that for a business to survive and prosper, it needs support from the economy it is working in. Without the support of the economic factors, it will be hard for the business to prosper.
No matter how good the management of a company may be, if the economic environment does not support the business, it will be very difficult for the business to keep growing.
A simple example of poor economics can be if a bank wants to expand its business in Venezuela. Since Venezuela is suffering from hyperinflation (the inflation rate in Venezuela is 1.3 million percent), no one in Venezuela will be willing to save and invest with the bank as hyperinflation will eat away any gains made.
So is there a way to identify such value traps early and get out of them while we still have some time (and money left)?
Here are few ways using which you can identify if the stock you want to buy or already have in your portfolio is a potential value trap:
How to tell of you own a value trap?
Here are few ways using which you can identify if the stock you want to buy or already have in your portfolio is a potential value trap:
Business Keeps Losing Market Share:
One of the most credible sign of a value trap is if a company starts losing market share. Such value traps occur when a dominant market player ceases the ground to new competition. There could be many reasons behind it, such as change in technology, change in consumer behaviour, better product innovations etc. For example, with arrival of digital cameras (change in technology) Kodak lost its dominant position in the market.
Similarly, with change in consumer behaviour to buy more herbal products rather than chemical based products, companies like Patanjali were able to gain significant market share in the FMCG segment.
Management missing business goals:
Every company sets some goals for the future of its business as a benchmark that it wants to achieve. These are predetermined management plans that a company follows in order to keep growing.
If the management of the company is not able to achieve its near term goals, or if the management has failed to achieve such goals previously, it’s a sign that the company is going to be a value trap.
Huge Financial Leverage:
While some debt is good for any business as it provides leverage, boosting return on equity to shareholder, too much debt is almost always dangerous and can ruin even the best businesses.
There are many examples in the Indian stock market where huge debt crushed the businesses, some of the names that were totally destroyed by huge debt are JP Associates, Suzlon Energy, Rcom. Vodafone Idea.
Companies with large debt could be one of the key triggers of value trap.
Suggested Read:
Characteristics of a Multi-Bagger Stock
Fundamental Analysis of Indian Stocks(Completee Guide)
How to start Investing in Indian Stock Market(Beginner’s Guide)
Conclusion:
What sets apart a true value investor and an average investor is his ability to avoid value trap. It is always advised to research a stocks before making an investment decision. If there is a significant decline in a stock’s price, find out the reason behind it, and try to assess if the problem faced is temporary in nature and solvable in the near future. Usually, companies that have a long history of successful business, the ones that have survived many business cycles should always be preferred investment, so it is always better to stick with tried tested and proven businesses for long term.
However, if you still get stuck in this situation, the best is to cut off the stock soon from your portfolio instead of averaging down a loser.
I hope you found this article on value traps useful and knowledgeable, if you like what you read, do not forget to share it with your friends.
Leave a Reply