One of the goals of every value investor is to avoid value traps. None of us want to buy a cheap stock and have it get cheaper. But even the best value investors get stuck with value traps.
Related Reading: Value Trap or Real Value Stock? What is the Difference?
Fortunately, we can take steps to minimize the chances of purchasing value traps. Here are some factors that may cause you to invest in a value trap instead of a real value stock.
6 Factors that May Cause You to Invest in Value Traps
1. Looking Backward Instead of Forward
A stock may look cheap when compared to its past earnings. But the market values companies on future earnings and growth of those earnings. What a company has earned in the past will have little to do with its value today.
Most financial sites quote P/E ratios based on past earnings. Looking forward means estimating future earnings and cash flows; then comparing those metrics, not past metrics, to the current price.
2. Outdated Business Plan
Avoid companies that have a business plan you don’t understand. If a company is unable to make profits or has a plan that is complicated and hard to explain – avoid it.
Bypass companies whose business plan has been outdated by new technologies. If a product or service is outdated it doesn’t really matter how many other good attributes the company has; it will most likely fail.
3. Poor Management
Look for management that owns their company’s stock; on the other hand, insider selling is a bad sign. If management is providing untrustworthy guidance it’s possible they lack the knowledge to lead the company. Quality management will give trustworthy guidance.
4. Accounting Fraud or Complicated Financial Reports
Any hint of fraud should eliminate a stock from consideration for purchase. Complicated financial reports should be a huge cautions sign. Real value stocks will have transparent financial reports and credibility with investors.
5. High Debt
The balance sheet may be more important than the income statement for sorting out value traps. High debt can cause problems with liquidity and solvency that can sink an otherwise good business plan.
A strong balance sheet is the foundation of a quality company and provides a margin of safety. When a company faces adverse conditions a conservative capital structure gives them the financial flexibility to meet the challenges.
6. Lack of Competitive Advantages
In todays cutthroat global markets a company must have sustainable competitive advantages. Before purchasing a cheap stock be sure the company has competitive advantages that will provide the cash flow and growth needed to raise the price of the stock.
Does the company have the ability to stay ahead because they are a market leader, have economies of scale, pricing power, differentiation of product, cost benefits, or have powerful brands. Without one or more competitive advantages the company may not be able to thrive.
Avoiding Value Traps
Looking backward instead of forward, an outdated business plan, poor management, accounting fraud, high debt, and lack of competitive advantages are all factors that could help you identify a value trap. Use these factors to weed out potential value traps; then focus on the real value stocks you might want to add to your portfolio.
Can you think of other factors that could cause a stock to be a value trap? Please share them with me!
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