Over the past 7 years, I have invested in several value trap stocks (SHLD, SHOS, SDRL, NADL, VRX) and lost about $150,000 which is huge!! I really need to learn to detect these kinds of value traps and avoid them.Summary
- what is value trap and how to identify it (value_trap)
- what are the characteristics of ‘Value Trap’ stocks (fron investopedia)
- how to avoid value trap
Value Traps: Bargain Hunters Beware!
SHAREInvestors often fall prey to value traps when they go hunting for a bargain. These “bargain” stocks may appear promising, but at the end of the day they are a big letdown for investors and they don’t go anywhere. In this article, we’ll show you how to hunt down a valuable stock without getting stuck in a value trap.
The Low Multiple Value Trap
Companies that have been trading at low multiples of earnings, cash flow or book value for an extended period of time are sometimes doing so for good reason – because they have little promise – and possibly no future.
A terrific example of this type of value trap was found in Rag Shops, a company that sold crafts. For years that company traded under or at book value and looked cheap by several measures. Its stock hardly ever budged, causing investor confusion.
The reasons for this stock deadlock were:
- The company had difficulty generating meaningful and consistent profits and was unlikely to generate institutional or substantial retail interest.
- Management was reluctant to get out on the road and tell the company’s story to retail and institutional investors.
- Competition from other craft outlets, including Michael’s and A.C Moore (Nasdaq:ACMR), was extremely stiff, and the company was unable to differentiate itself.
Rag Shops ultimately filed for bankruptcy, and investors that were lured in by its once low price-to-book multiple ended up with nothing more than a tax loss. (To learn more about these metrics, see Value By The Book, Digging Into Book Value and Fundamental Analysis: A Brief Introduction To Valuation.)
Lack of Catalysts
Companies and stocks need catalysts in order to advance. If a company doesn’t have new products on the horizon or expect to show earnings growth or momentum of some kind,consider avoiding it.
A company’s history should never be overlooked, and it should be compared to what the company’s current financial statements look like. If the company cannot improve upon its position operationally,it may have trouble competing with companies that can. Utimately, the company will probably also have trouble garnering interest from the investment community.
Many seasoned investors and sell-side analysts wait until a catalyst gets ready to hit the market and buy or recommend the stock then. Once the catalysts evaporate or transpire they will jettison the stock.
Multiple Kinds of Shares
Some companies, like Berkshire Hathaway, have Class A shares and Class B shares. The difference between the two classes of stock depends on the situation. Class B shares may contain super (or, advanced) voting rights. For example, one vote of Class B shares might be the equivalent of the votes of five Class A shares. Class B shares may also contain a special dividend or other special right not granted to the average common shareholder.
The average investor should be wary of investing in a company with two classes of stock. The reason for this is that the owners of the Class B shares generally are insiders or large investors and the company tends to focus on keeping those investors happy rather than paying attention to the common stockholder. (To read more about insiders, see Delving Into Insider Investments.)
Small Floats
There are many parameters that a company or stock must meet in order for the average institution to take a position in it. Many funds won’t take a position in a company unless its stock trades for $10 or more. Fund managers and/or analysts may also be forbidden from getting involved in companies whose annual sales total less than $1 billion, or that are unprofitable. Of course there are usually other prerequisites and parameters as well (for institutional participation) and they usually revolve around a company’s float.
Companies with a small float or with few shares that trade in the public domain are unlikely to garner institutional attention because those investors will have trouble acquiring and ultimately disposing of large quantities of stock. When institutions cannot participate in a stock, the shares tend to languish; by extension, they may become a “value trap”.
Tightly Held Companies
It is usually a positive sign when insiders at a company own large chunks of their company’s stock, as it usually gives the insiders ample incentive to find ways to enhance shareholder value.
Many institutions and entities that can move stocks (ie. mutual funds and hedge funds) will usually not get involved in a company if it has a high percentage of insider ownership. If insiders own a high percentage of the shares, the investing institution may not be able to influence the board of directors or to have a say on corporate governance issues. This lack of institutional interest could cause a stock to seriously languish.
Bottom Line
Although a company may seem like an attractive investment candidate because of a low multiple, unless it has catalysts on the horizon, interested institutional investors, insider incentives and ample floats, the stock could lead you into a value trap.
In essence, value investing is the practice of identifying financially sound companies with solid future growth prospects that are available at attractively low valuations, with the company’s stock trading below its intrinsic value. Some value investors have been drawn into value traps, in which they buy into stocks that may be low priced but that are not genuinely undervalued and whose stock prices may fall substantially further due to company or industry specific conditions that are long-term problems rather than just temporary setbacks.
There are relatively low-priced stocks that are genuine value investing opportunities, and then there are stocks that are low-priced value traps. Learn to look beyond just a low price and maintain a focus on strong fundamentals for a company and the industry in which it is engaged. Here are five warning signs that a stock may be a value trap rather than a real value investing opportunity.
1) A Bad Business Model
No matter how promising a company’s statements on its website may seem or how attractively low its stock price may appear, be wary of any company that doesn’t have a business model that is both easily understandable and clearly aimed at being profitable. If you can’t easily and clearly see how the company’s business model should lead to success and profitable revenues, it’s probably best to avoid the stock no matter how temptingly low the price may look. Be especially wary of companies that rely on outdated technology. In today’s rapidly changing economic world, a company offering a product or service that is outdated, or soon to be outdated, is in serious trouble. This kind of trouble usually results in a stock price that just continues to drop. Technological obsolescence has led to the downfall of many a business in the past couple of decades.
2) Price Too Cheap Compared to Earnings
The price-to-earnings ratio (P/E) is a good financial metric to consider when determining whether a stock is really a bargain or a value trap. If a company’s stock price has dropped to the point where it is unreasonably cheap in comparison to earnings, this is often a strong indication that the company is fundamentally unsound. Since the market generally prices stocks in relation to future expected cash flows, consider the forward P/E ratio as well as the trailing P/E.
3) Too Much Debt
Many promising businesses have been undone and sent into bankruptcy by allowing themselves to become overly leveraged. The adage is true that it’s much easier to pile up debt than it is to get rid of it. If a company’s revenues and stock price have declined, the interest on its outstanding debt becomes a larger percentage of revenues and income. When this happens, the debt usually becomes increasingly difficult to manage. A company carrying a dangerously high debt load has very little room for error or even for minor setbacks in the marketplace. It’s probably best to shy away from stocks that have substantially higher debt to equity (D/E) ratios than the industry average.
4) Lack of Competitive Advantage in the Marketplace
Virtually every market sector is increasingly competitive. If you can’t look at a company and clearly see that it has a competitive advantage, then it very well may not have one. Consider potential sources of market advantage, such as unique products or proprietary technology, brand identity, less expensive suppliers or production costs, cash reserves or location. Unless a company has at least one competitive advantage that should allow it to succeed on a higher level than its competitors, it is not likely to thrive and grow, and that applies to the value of its stock as well.
5) Lack of Insider Buying
One of the clearest warning signs to stay away from a stock is a lack of insider buying or, even worse, signs of substantial insider selling. Include hedge fund and mutual fund managers in the group of insiders, and be careful if the percentage of funds holding a stock is dropping substantially. If company insiders aren’t anxious to scoop up shares of the stock at what looks like a bargain price, then the stock probably isn’t such a bargain after all.
