September 9, 2022
Everyone likes a bargain. Unfortunately for retail investors, they are few and far between and can be fraught with peril. When seeking bargain stocks, it is easy for individual investors to fall into value traps – stocks that appear to be a bargain but “trap” the investor’s money as the stocks languish, often for good reason.
Many people follow the principles of value investing – they study companies and the numbers behind them to find undervalued stocks they hope will provide solid returns over the long term. Everyone wants to find that diamond in the rough; that undervalued stock that other investors seem to be ignoring despite numbers that seem to show strong short-term fundamentals.
A value trap is a stock that looks cheap, but whose price never seems to increase. These traps are caused by a variety of reasons and the most common include situations like: permanent industry changes (i.e. buggy whip manufacturers pummeled by the arrival of the Model T); cash flow problems (i.e. investment banks during the 2008 Great Recession); peak earnings traps (i.e. investing at the wrong time in sectors like construction, oil and gas or other segments that experience booms and busts); and lack of innovation (i.e. retailers caught flat-footed by online sellers).
Simply put, value traps occur when a stock’s current fundamentals don’t reflect its future fundamentals. For example, if a company is earning $100 million today and has a market valuation of $1 billion, it might look inexpensive at its 10X multiple. However, if future earnings turn out to be $50 million, the 20X multiple at a $1 billion valuation looks a bit more realistic or even expensive.
Savvy retail investors will find there is often a reason for the lackluster price, but might still be lured in by the chance for a quick buck. It is difficult to see the trap when the numbers most investors use to weigh an asset purchase are giving them incomplete or misleading information. The trap appears when the stock looks like a bargain because it has been trading at low valuation metrics. Valuation metrics are used to determine the fair value of a company.
Valuation can be done in a number of ways and deciding the value of a company is always an opinion. Valuation metrics can help because they provide ratios and models that can give investors an idea of what a company may be worth. These valuation metrics can come from a company’s financial statements or can compare the market price to statistics from the company in question.
Even when looking at valuation metrics such as multiples in terms of price to earnings (P/E), price to cash flow (P/CF), or price to book value (P/B), investors can still fall into a value trap. Avoiding them completely is nearly impossible. Investing in mutual funds and passive investing funds like ETFs can help keep your portfolio diversified and partially protected. The impact of a value trap is minimized by keeping the position size of individual stock holdings low.
That might be impractical for some retail investors, so at a minimum, careful research is needed prior to any asset purchase. It is important to note that these “traps” are not set on purpose by the companies in question – there is almost never malice in value traps. They simply appear for the reasons listed above.
There is always a reason as to why a stock price is low. As an individual investor, it pays to figure out why the price is low and whether the causes of the bargain-basement stock price are permanent or temporary. As with the purchase of anything, buyer beware.
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