What is the Value Trap?
Value trap is when the current price of the stock appears to be undervalued on the basis of fundamental valuation parameters like Price to Earnings, Price to Book Value, Price to cash flow ratio over a period of time, however, in reality, these stocks are not worthy of investments. This could be because the company doesn’t have much to offer in the future, lacks in future planning of product line, company’s competitive behavior, innovation in the field of operations, ability to manage cost, etc.
- Available at Attractive Price Compare to Valuation Metrics: Such investments are priced lower in the market compare to valuation metrics like Price to Cash flow, Price to Earnings, Price to book value, etc.
- Inconsistent Profit: If investors decide to research more in such stocks, they will find inconsistency in profit over multiple years. Growth of stocks depends on earnings consistency and growth, if it’s not there, resulting in degradation of stock in terms of valuation.
- No Future Planning: For every business, it is important to plan its future process, whenever a company is in the product, which although trending today but, a future requirement in such a product is uncertain, such stocks look attractive today but, proved to be value trap for investors.
- No Control Over Cost: Due to various factors or development in technology, which are not adapted by the company cost of production is still high, and if the company is not able to manage its cost structure, face problem in the future.
- Bad Management: Good management is the life of the business to survive and prosper in the future.
- Accounting Issues: Due to manipulation, tactics used in accounting much such value trap business looks attractive in books compare to their market price.
Value Trap Example
Stock ABC ltd is available at an attractive price to compare to its earning at 5X, compare to its average of 20X earning for the last one year. The price to book value ratio of ABC has dipped below 1 for the last nine months. Previously it was around 2.
For many investors, such indicators mean undervalued company and good investment opportunity in terms of value investment. But, many investors suffer a loss due to a lack in terms of studying complete fundamental analysis of the company.
Causes of Value Trap
- Lack of Research and Development in Product Line: Every company needs to perform research and development in order to survive and grow in the future. If a company does not continuously research new products and services and make it available in the market, it may look attractive today but won’t survive in the long run. Historical performance should be analyzed and compared with the present, and for an investor, it is important to understand what is future planning of the business.
- Less Focus on Investors: Many times, companies focus on large investors and concentrate on them. At the same time, a higher portion of ownership of shares is by insiders and large investors, which in turn results in ignorance towards the common investor. It is important for an investor to understand holding patterns in the company before investing.
- Various Small Factors: Many parameters, which affects investment decision on an institutional level to invest in certain companies like stock price, revenue, etc. many institutions prefer to invest in a company after it shows a certain level of growth in the market. Many small companies in which institutional investors are not yet involved look attractive from a price point of view but, turns out to be a value trap.
- Control Over Holding: Many times, it is considered a good sign if the company owns a large part of its shares in the market. But, if institutions like mutual funds or hedge funds don’t own enough percentage of stocks to influence decision making or ability to generate the right amount of vote on disagreement in business management which, results in a lack of interest in institutional investors and such stocks becomes value trap for retail investors.
How to Avoid?
- Avoid Cheap Investment: Investors should concentrate on value and growth instead of price. Companies with the combination of both component i.e., value and growth, prove to be the much better investment.
- Fundamental Analysis: 360-degree analysis of the company is very important before making any investment decision. And such analysis should include all pros and cons of business with various points of view.
- Free Cash Flow: How much company have after paying out its free cash flow and how they are utilizing it.
- Cash Flow Research: How much percentage of cash flow comes from operating activities, investing activities, etc. as such information tells the usability of business operations and investment decisions.
- Debt to Equity: Asset vs. liability comparison is very important in analysis. For an investor, it is important to understand all rations and not to depend on certain ration in the decision process.
- Industry and Sector Overview: Understand Industry and sector overview its pros and cons in the market. How peers of the company are performing in comparison.
- Past and Present Analysis: The Company’s past, present, and future analysis is important and can be done by observing the decision process in business, performance, and thorough understanding of financial statements.
- Stock Holding Patterns: Understanding of stock holding patterns in a company is a very important part of investment decisions because many times, the value trap is the result of alteration in holding patterns in the company’s shares.
- Growth: Growth in terms of revenue, profit future aspects innovation is important for any business to survive in today’s market.
- Cheap Investment: Cheap investment opportunity, which looks like today’s value trap, might turn into value investment and can create huge wealth for value investors if done properly.
- Undervalued Investment Opportunity: If investors did enough research, such value traps can be a good opportunity to invest in undervalued stocks and over the period generate wealth from such investment.
- High Risk: This investment can result in loss of entire capital. If an investor is not careful, he/she will end up losing wealth due to the attractive market price of the investment.
- Uncertainty: These are uncertain in nature; some might turn to be good investment decisions while others may turn out to be bad.
For any investors, it is important to understand and analyze from all aspects instead of concentrating at attractive market prices in comparison with some multiples. Many times even expensive investment at higher prices turns out to be better instead of looking at cheap investment options.
If an investor wants to look for such value investment in undervalued companies, he/she must ask certain question i.e., Why the market price of such investments are low over so much time, what are future aspects of business, holding patterns in stocks, comparison with peers and past, present and future analysis and forecast of business. This can be avoided if an investor understands and performs research on the business before making any investment decision.
This has been a guide to What is Value Trap & its Definition. Here we discuss the characteristics of a value trap, causes, and how to avoid along with examples, advantages, and disadvantages. You can learn more about from the following articles –