Value investing is one of the most popular investment strategies. The stock market has rewarded value investors with exponential returns. No wonder why so many new investors are intrigued by this successful strategy.

However, there is one aspect that many investors look over and fall prey to – the value trap.

Let’s see what it is.

What is a value trap?

It is precisely what the name says – a trap.

Value traps are stocks that seem like value stocks but are actually traps in disguise. These stocks will be trading at low stock prices relative to what is considered as their fair value (or book value), and will also have valuation ratios in lower multiples. This will trick an investor into thinking that it is a value stock available at a discount.

Value traps appear to regular investors as potential winners, especially for value investors who are looking to buy stocks on a bargain. But in reality, these stocks often have very little promise, and possibly no future. Investors on seeing this ‘opportunity’ rush to buy these stocks end up losing their money.

The catch here is that the stock price is low not because it is trading below its intrinsic value. It’s just because the company doesn’t have much potential and is likely to be on its way to bankruptcy.

How does a stock become a value trap?

To understand this, let’s first look at how a regular stock becomes a value stock. This happens when a stock that has strong fundamentals and huge long-term potential trades below its intrinsic value. This might be because the market hasn’t realized the stock’s true value, and when it does, the stock price rises above its intrinsic value, and the investor makes money.

However, in the case of a value trap, the stock might be trading at a low price because of different reasons. It might be the case that the company’s long-term outlook has changed, or is about to change due to reasons that are not immediately apparent. The stock might appear to have good fundamentals, but there are underlying issues that could potentially affect the long-term prospects of the company.

For example, a company losing market share to a strong competitor might be at the risk of losing out revenue and profits – which could have a negative impact in the long run. But this might not be obvious in the income statement or balance sheet.

Value trap indicators

There are various instances where a stock might end up being a value trap. A factor that indicates that a particular stock might be a trap is referred to as a value trap indicator.

Let’s look at each in detail;

Earnings and cash flow

Income and cash flow statements are something every investor looks at when analyzing a company’s fundamentals. However, an income statement or a cash flow statement doesn’t tell you the whole story. A company can have good earnings and still go bankrupt.

Consider the case of some investment banks at the time of the financial crisis during 2008-2009. These institutions were funding long-term liabilities with current assets. So their financial statements looked healthy, but they were hanging by a thread. Soon enough, most of these institutions went bankrupt, and the shareholders were wiped out overnight.

Business model

This is something that many investors neglect and as a result, can lead you right into a value trap.

In a nutshell, understanding the business model involves finding the answer to three questions; a) how do they make money, b) how do they spend their money, and c) and what makes them any different from a competitor.

If there’s a company whose business model is hard to understand, and you can’t find a path to profitability, it might not be worth investing in it. Another question to ask  – is the business model sustainable? Meaning can it withstand a recession, technological advances, etc.

Walmart is a great example of a company that can withstand a recession and technological disruption.

Major changes in the industry

Changes are inevitable, and they happen all the time – some of them are obvious, while some aren’t. Major changes in an industry can change the long-term outlook of a company, in a short period of time. More importantly, these changes won’t be reflected in the financials of the company until a few quarters or years later. Meanwhile, investors will rush to buy the stock as it seems cheaper compared to its previous prices.

Airlines are a good example of this. The global pandemic brought a lot of change to the airline industry – because people stopped flying. And then people found a way to reach one another without traveling hundreds of miles – using Zoom and other video conferencing platforms. If you were an investor who has been waiting to own airline stocks, you see the price decline the pandemic has caused, and you jump at the opportunity.

Guess what, you’ve just fallen prey to a value trap.

Peak earnings or cyclical industries

Then some companies belong to cyclical industries. A cyclical industry is an industry that is dependent on business cycles for revenue generation. So their profits rise and fall predictably. The businesses in cyclical industries, expand and contract, and expand and contract again – in cycles. Their ability to make money largely depends on the overall economic conditions. Hotels, textiles, and construction are some examples of cyclical industries.

When they go through a favorable period in the business cycle, their earnings might shoot through the roof. This results in a significantly low P/E ratio, which makes the stock appear largely undervalued. Now given the fact that most investors look at the P/E ratio to find undervalued stocks, suddenly these stocks might seem like a lucrative investment. However, investors fail to realize that this might be the first time they’ve had such results in years or even decades.

Management

This is another aspect of a company that gets lost in the world of numbers, ratios, and whatnots. Good management can build the company from the ground up and keep it growing, and a bad one can drive it right into the ground. The management makes strategic decisions that decide the long-term potential of a company. So be well aware when they are giving out signals.

Are the insiders buying shares? Or are they selling them? Do they have skin in the game – how much of the shares do the executive team members own? These are some questions you need to ask yourself, before jumping into a value stock – to make sure you don’t end up in a value trap.

Chewy – one of the stocks that we recommended has insider ownership of 21.99%. It means that about 22% of all the outstanding shares are owned by the company’s management, directors, promoters, etc. basically people who know best about the future of the company. Significant insider ownership ensures that they have skin in the game – they are accountable for their actions that drive the company.

Companies without a moat

Okay, you have checked all of the boxes above  – they have a good business model and management, they’re not in a cyclical industry – it all seems good. But are they any different from their competitors? More importantly, is there anything that sets them apart from their peers in the industry? What if a new competitor comes in – can they imitate what our company does – what if the competitor does it in a better way?

The point is – if they don’t have sustainable competitive advantages (also known as moats), that can set them apart from their competitors, they’re unlikely to survive competition over the long run. And they could just be another value trap.

Consider Apple for example. If you’re an iPhone user (or any Apple products for that matter), you know best about the edge Apple has over its competitors. Their brand value is just one of their sustainable competitive advantages that just cannot be imitated by their competitors – new or old. And if you’re not an Apple user, you know how the prices seem ridiculously high – but still, people line up outside their store whenever they launch a new product. That’s because of the pricing power that they have; they can charge higher prices than their competition and still get away with it, without losing market share.

How to use value investing to avoid value traps?

Now that we know the characteristics of a value trap, let’s see how you can avoid them.

Do your homework; thoroughly

I can’t stress this enough.

You need to do due diligence on any stock that you buy, and you need to do it thoroughly.

That means not just looking at the numbers, but doing a deep dive into their 10-K form, investor presentations, etc. When they hear about a stock for the first time, most investors quickly jump onto a platform like Yahoo Finance and take a look at all the numbers available – P/E, P/B, P/S, ROE, ROA, ROIC, etc. and decide whether its a good or bad investment.

Don’t get me wrong here; it’s a good idea to look at numbers, and Yahoo Finance is a great place to start – as it gives you a detailed look without being intimidating. But you shouldn’t make an investment decision solely based on that. Because that might just be the easiest way to end up in a value trap.

You see, the numbers only tell you one side of the story. There might be underlying issues that pose a risk to the future of the business – the company might be facing a lawsuit from their biggest customer, they might be losing market share, or their products are getting outdated, etc. Therefore, wait for a while to make sure you’re not buying on ‘instinct’. And in the meanwhile, take a look at their investor presentation – it is usually short and easy to understand. And if you’re still interested, take a look at their Form 10-K. That will give you a detailed look at the business and operations.

And always remember, if you can’t find some sort of negative information about the company, you haven’t looked deep enough. Now, this information needn’t necessarily be bad enough to sell the stock, but more like the kind of information that gives you a fair picture of the risks of investing in the company.

Bottomline

Investors should be well aware of the risk value traps pose. This is especially applicable for value investors, as they’re the ones who are more exposed to these. There is also the risk of buying stocks by looking only at dividend yield, only to end up in value traps.

It is important to note that, Warren Buffett, however, had the audacity to identify false value traps (which is nothing but a value stock) and make a lot of money. The important part is being able to tell the difference between a value stock and a value trap.

To know more about value investing and the 20 stocks you should buy for the long term, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.