We all love cheap things, and in the investment circles a lot of people also love “cheap” companies based on their valuations, for they are not really priced at their actual value, thus there is money to be made in the price-value difference. Whether you are a value investor, a growth investor, a dividend investor or a combination of either two or all three, the potential is there.
However, there is also this term that floats around the investing community, and that is “value trap”. This phrase is usually used, seen and/or heard when sourcing for “cheap” companies.
What Is A Value Trap?
According to Investopedia, a value trap is “…a stock that appears to be cheap because the stock has been trading at low valuation metrics such as multiples of earnings, cash flow or book value for an extended time period”1.
In other words, a company can be trading at below its value for a very long time, with no indication of the price reaching its actual valuation. This is bad as if you happened to buy a cheap company hoping its price will go up but did not after a relatively long time, and then you may be stuck with a value trap.
How To Avoid A Value Trap
Simple, just do a full-scale fundamental analysis (FA) on the company. Typically, some investors fell for a value trap by focusing too much on valuation numbers/ratios and ignored the rest. Some investment literature had suggested looking at other things instead of just valuation, such as (and not exhaustive):
- earnings per share over the past few years
- debt to equity ratio
- free cash flow
- the company’s sectorial trends
- management vision, etc.
You could apply the three-tiered FA model in The Bedokian Portfolio (Company, Environmental Factors, Economic Conditions)2 or any other FA methods and styles that you have learnt to distinguish between a really “cheap” company or a value trap.
Not All Value Traps Are Bad
Sometimes there are other factors besides bad fundamentals that made a company a value trap. A company may be profitable, have a steady cash flow, not much debt and in a stable sector/industry, yet it is still not priced at its true value. This could be due to its obscurity and being away from the public (and analysts’) eye, or the sector/related sector(s) that the company is in is not due for take off. Eventually, they may become the next value, growth and/or dividend companies, but exactly when is unknown.
And from a Bedokian Portfolio investor’s point of view, sometimes being invested in a value trap is a good thing, particularly if the company is in good financial health and paying good dividends consistently. Do your due diligence when you are exploring this option.
1 – Investopedia. Value Trap. https://www.investopedia.com/terms/v/valuetrap.asp(accessed 27 Oct 2018)
2 – The Bedokian Portfolio, p85