Have you ever bought a cheap stock, which later got cheaper and cheaper?
If yes, then you might already have met with- Value traps.
Value traps are those stocks which may seem like a value stock because of their cheap valuation. However, in actual, they are garbage stocks. Unlike value stocks, these value traps do not have true potential to give good returns to their investors and that’s why their price keeps on declining for a continued period of time.
Why do investors fall in value trap?
There are some stocks which may appear cheap because they are trading at a low valuation metrics such as PE, price to book value ratio, cash flow ratio etc.
The bargain hunters keep an eagle eye on these stocks as they appear cheaper compared to their historical valuation or relative to the market.
These investors buy these stocks at a low price considering them as a value stock. However, the problem arises when the price keeps on dropping for an extended duration of time.
Here, instead of purchasing a value stock, the investor has fallen for a value trap.
Real value stock vs value traps
The real value stocks are those stocks which are trading below their intrinsic value. The reason for their cheap valuation may be either temporary factors or because the market has not yet realized their true potential.
Few common characteristics of value stocks are consistency, strategic advantage, strong business plan, growing cash flow and high-quality financials. Further, these stocks can be considered value stocks only if they are bought at a significant margin of safety by the value investors.
On the other hand, value traps are those stocks that are trading at a low valuation because of long-term or permanent setbacks (factors).
These stocks are not actually trading below their intrinsic factor. They are just trading at a low valuation compared to their historical valuation or relative to the market (which might be even above its true intrinsic value).
The value traps are those stocks which are ‘not’ cheap because the market has not realized their true potential or because of some temporary setbacks. These stocks are trading at a cheap valuation because the company has either lost its fire or else its fire is fading away.
Value trap stocks lack catalysts or momentum to retrace its original growth track.
Here are a few common signs that the cheap stock is actually a ‘Value Trap’:
1. Declining earnings
2. Business plan
3. Poor Management
4. High Debt
5. No change in management compensation structures
6. Poor financials and accounting principles
7. No change in capital allocation method
8. Strategic disadvantages
9. No growth catalysts
Summary:
The actual goal of a value investor is to avoid value traps. Therefore, my first suggestion to every value investor would be to research the stock properly before investing.
However, even seasoned investors sometimes fall into the value trap and buy garbage stocks considering them undervalued.
In such a situation, the best you can do is to understand the problem and cut off the stock as soon as possible. Do not purchase more stocks in order to average down or hold the stock long enough with an expectation to break even. The faster you can get rid of that stock, the better it is for you.
In the end, let me tell you the law of holes: “If you find yourself in a hole, stop digging”.
Image Credits:
Creator:Rudyanto Wijaya
Credit: Getty Images/iStockphoto
Copyright: Rudyanto Wijaya
Yorumlar