The term “value trap” can be used to describe stocks or other investments that may seem like a bargain but shouldn’t be taken at face value. Knowing how to spot a value trap and how to build a portfolio using a value investing approach can minimize risk. Here’s what you need to know about value traps.
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What Is a Value Trap?
A value trap is a stock that seems undervalued, but isn’t. The stock may have all the earmarks of a value stock: Low price to earnings ratio, low price to book ratio or a high dividend yield. As a result, it signals to value investors that it’s potentially a good buy. The trap comes when the stock doesn’t perform as the investor expects.
This is the fundamental nature of value investing. In other words, investors buy undervalued stocks and hold onto them for the long term. The goal is to identify stocks that the stock market undervalues. Then, you add them to your portfolio and wait for them to appreciate in value. The payoff comes when you sell those stocks later for more than their purchase price.
With a value trap, that payoff never comes. While the stock may look undervalued, its value assessment is actually correct. As a result, the stock’s value may change very little over time. In other words, you won’t reap big returns. In the worst-case scenario, the stock’s value actually declines. Consequently, you could take a loss by selling stocks for less than what you paid for them.
How Value Traps Happen
A value trap often indicates a lack of transparency or information about the company’s fundamentals.
For example, a company could look great on paper with strong cash flow and low price to earnings ratio. But those things could overshadow high-interest debt or other liabilities that make the company less profitable. If the company can’t bring its balance sheet back in line, the value trap is set.
A value trap situation also can occur if a stock is tied to an industry in a boom period of the business cycle. Investors may see a low stock price, relative to competitors, and assume it’s a bargain. As the industry’s boom peaks, earnings may increase across the board. As a result, investors assume that translates to value. When the boom ends, however, earnings and the stock price can deflate.
Remember the old investing rule: Past performance doesn’t guarantee future results. In some cases, an investor focused on prior results may buy into a value trap. They assume the company will maintain its market share and grow in value. That can backfire, however, if the company gets squeezed out by new competitors. Similarly, existing competitors can develop new technologies, products or services to expand their customer base.
How to Spot and Avoid a Value Trap
You can’t rely on pricing trends alone to tell you whether or not a stock is undervalued.
For example, say you’re eyeing a stock that’s paying out a sizable dividend to investors. The share price may seem low compared to other companies in the same industry. As a result, you think it might be a good buy for the long term. But you must consider the sustainability of the current dividend. Consequently, you need to look at the company’s debts, revenue and profits.
If the company uses too much free cash flow for dividends, it may not cover operating expenses. That can lead to debt, which in turn can lead to a decline in dividends . From there, it’s a short jump to a drop in share prices.
Value Trap Checklist
When evaluating stocks as potential value investments, try sticking with the basics. Consider the following:
- Free cash flow, which means how much cash flow a company has after paying out expenses.
- Where the bulk of cash flow comes from, i.e. operating activities versus investing activities.
- Debt to equity ratio and assets vs. liabilities on the balance sheet.
- Overall momentum within the company’s industry or sector.
- Current and historical profit margins.
- How often the company issues new shares of stock,
- Sales growth (or lack of it) for the previous twelve months versus earnings.
Together, these factors can give you a more complete picture of whether a stock is undervalued or not. One way to minimize the odds of falling into a value trap is by avoiding individual stocks as an investment. You might choose a value stock mutual fund or index fund, for example, that diversifies across multiple investments. This can help you capitalize on the principals of value investing while spreading out risk in your portfolio.
Value traps can lead to headaches if you’re buying shares of stock in the belief that those shares will steadily increase in value. A stock may disappoint you if its price doesn’t take off as you expected. Being able to recognize the signals that a stock’s value is accurate, or that it may be a value trap, can help you avoid the pitfalls in your portfolio.
- Consider talking to your financial advisor before making new investments if you’re concerned about falling into a value trap. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Do you need help planning out your investment returns? Try using SmartAsset’s investment calculator to prepare.
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