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What is a value trap? And how do you avoid it?

By Douglas Thane

Finding undervalued stocks is the goal of many investors but many assets are priced that way for a reason.

Value investing can be lucrative and finding truly undervalued stocks is the goal of many investors. The problem is that the majority of stocks which appear undervalued are at that price because the market has recognised a threat to future growth.

A value trap is a stock that on the surface appears “cheap” against valuation metrics but is valued properly due to underlying weaknesses and risks. An investor thinks they have spotted value in the market and invest but find themselves in a continuous loss situation with no reasonable potential to regain the investment.

Value investors are always looking to find undervalued or cheap stocks that have been missed by the rest of the market. The age-old saying of “buy cheap and sell high” is an offshoot of the concept of value investing. This simplified strategy can trick both inexperienced and experienced investors as identifying cheap stocks based purely on historical performance and earnings metrics can fail to provide the full reason as to why a stock price is low. If past performance was a true indicator of the future value of a stock, newspaper companies and Blockbuster would still be good investments. The truth is that many times stocks that appear to be cheap are priced that way for a reason.

Avoiding value traps

Recognising value while avoiding value traps is naturally much more difficult than it sounds. Many value investors use metrics such as the price to earnings (PE) ratio and price to book (PB) ratio to identify companies which are priced below their true intrinsic value. The issue of a value trap arises when based on these metrics a stock appears undervalued, but the company is in reality just failing to grow or maintain market share. To avoid a value trap, investors must understand the reason a stock is underpriced in its entirety.

Ineffective or unmotivated management can be a significant factor in the identification of a value trap stock. Management compensation packages which are tied to performance indicate a strong motivation to grow the company while guaranteed compensation can indicate an increase in risk and the potential for continued underperformance. Some of the other indicators that a stock is not undervalued but that the company is just underperforming are:

  • High debt loads
  • Eroding market share
  • Declining industries
  • Strategy drift
  • High rate of management turnover
  • Low S&P quality rating
  • Filing financials late
  • Negative or low cash flow

Avoiding the investment in the first place is a lot easier to stomach than selling a stock at a loss after realising you have bought a value trap. As the famous investor Warren Buffett said, “It is far better to buy a wonderful company at a fair price than buy a fair company at a wonderful price.” There are times where even after diligent research you will find yourself invested in a company that you now feel has no chance of future growth. In this scenario, inexperienced investors can try to chase their losses, buying more stock as the price continues to drop with the expectation or that the price will climb closer to historical levels. The only viable strategy at this point is to sell and accept the loss. The major difference between the best institutional investors and amateur traders is not that they will never fall into a value trap but that experienced investors will accept the loss and sell as soon as they realise they are in the value trap.

Value trap example

An example of a stock which may be a value trap is AT&T (NYSE:T). AT&T has a long history as a dominant player in the telecommunications and entertainment industries and with high dividend payouts could seem like an attractive investment. On the surface, an investor could think AT&T is suffering from a short term slow down in the market and is poised to regain previous growth rates. By analyzing the entire scope of the operating environment, the same investor may come up with a completely different conclusion.

In the past five years the S&P 500 index has grown by more than 50 per cent while AT&T share price has declined by more than 7 per cent. Again, the idea that there is room for growth may seem attractive but there are good reasons for the decline. AT&T operates in a quickly evolving industry, direct to consumer cable TV. This business model is declining rapidly as households switch to streaming services with no possibility of returning to the old model. AT&T has thus far shown a resistance to innovating or changing its business model and is lagging behind relatively new competition such as Netflix.

Another of AT&T’s major business lines, wireless communications, has seen an influx of new competitors and with the market saturated major players have begun to compete on price. This is eroding already thin margins and appears to be the new normal as customers will be reluctant to go back to more expensive business models. On top of these industry wide red flags AT&T is also carrying an extremely high debt load and there have been significant sell offs by company insiders in recent months. There is always a chance for some unforeseen innovation, merger or acquisition to change the tide for AT&T but at this point it seems to be an investment which will likely continue to decrease in value.

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