What is a Value Trap?

Have you ever bought something for a cheap price that seemed like a “steal deal” but the product or service underwhelmed you? In the world of money management, a similar situation is called a value trap. Some stocks appear to be trading at a lower price and attract investors looking for a bargain. The illusion leads investors to believe that they can invest in stocks and beat the market, but in reality, they get either negative or slumping returns. Value traps look cheap compared to past valuation multiples of stocks or peers and common market multipliers, which is like a moth to a flame for investors.

They are often trading at low 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) for a long period. The low prices of value traps are also associated with longer periods of low multipliers. Value trap investments often turn out to be bad investments, as low prices and multipliers are due to long-term financial instability and low growth potential. Minimal or no efforts to improve the company’s situation like cost control, innovation, control, and competitiveness are telling signs of equity being a value trap.

Causes of Value Trap

There are several reasons why value traps occur. If a company does not invest in constantly researching new products and services and doesn't bring them to the market, the stock will sooner or later become a value trap. It might look attractive today but it won't last in the long run. Therefore, investors need to understand the company's plans.

How to identify a Value Trap?

It's important to remember that buying a stock just because the stock price has reduced can lead to a value trap. In general, a company that trades for a long time with low returns, cash flow, or book value may have the little prospect and no future, even if the price of its stock looks attractive. Equities are a value trap for investors if the company's competitiveness, ability to innovate, cost control, and/or the company's management has not significantly improved.

Here are some signs that can help you spot a value trap:

1. Analyze the competitors

Stocks should not be analyzed as independent assets. Always compare the company’s performance to its competitors in the industry. If the company is at the top of the operational cycle but still grows slower than its peers in the industry, additional research is needed. Find out the reasons for its poor performance.

2. Innovation

In a fast-paced business world, companies need to innovate and bring newer and better products to be sustainable. If a company doesn't have new products on the horizon nor expects to show earnings growth or momentum of some form, consider avoiding it.

3. Multiple Classes of Shares

Owners of Class B shares are generally insiders or large investors, and the company focuses on keeping those investors happy rather than caring for ordinary shareholders. Therefore, as an average investor, you need to be careful about investing in companies with two classes of stock.

4. Dispersed Ownership

When the ownership of a company is highly dispersed, small investors have a minimal stake. There will be a lack of institutional interest which can seriously undermine the growth prospects of stocks. A tightly held company with a high majority being owned by insiders has a more vested interest in the growth of the company. If the insider owns the majority of the shares, smaller investors may not be able to influence the board or comment on corporate governance issues.

How does a value trap work?

A value trap has an attractive stock price to lure investors. They buy these stocks with the expectation that it is currently undervalued and therefore, cheap. They expect the stock prices to appreciate in the future, thereby earning them profits. However, instead of giving returns, the stock prices continue to fall, thereby causing a loss of value.

For example, if you buy a cyclical stock at the peak of its cycle, the stock prices may seem attractive given the historical growth rate. As a result, the price-earnings ratio (P/E) appears to be significantly undervalued. Interestingly, many such companies are the most expensive when the P/E looks low, and the cheapest when the P/E looks high. In such situations, it is advisable to check the PEG ratio or payout adjusted PEG ratio.