One of the most important and difficult components of value investing is determining whether you have found a real value stock or a value trap.
What is a Real Value Stock?
A real value stock trades at a bargain price because the price trades below the company’s real or intrinsic value. The price is low because of temporary factors.
Characteristics of a real value stock would be consistent and/or growing cash flow for shareholders, a business plan for products that have sustainable competitive advantages, and quality straightforward financial statements. In addition, the price should be low enough that it provides a margin of safety; therefore the purchase price you are willing to pay should be substantially less that its real worth.
What is a Value Trap?
A value trap is a stock whose price appears to be a bargain but in fact is not selling at a price below its intrinsic value. This is usually because something is different, or is going to change, that affects the earnings or cash flow of the company. The price is low because of long term or more permanent factors.
Have you ever bought a stock you thought was cheap and it just got cheaper and cheaper? That is a value trap. It appears to be a bargain compared to its previous price, but in reality something has changed and the lower price is discounting or warning of deterioration or change ahead.
6 Factors That Might Indicate Your Stock is a Value Trap:
1. Stock Earnings and Cash Flow Are Collapsing
If the stock price is very cheap compared to past earnings this is a warning sign. Past earnings have little effect on the future stock price. The stock market is looking to discount future cash flows. If a stock price has fallen to the point where it is absurdly cheap compared to past earnings, that is a clue something is deeply wrong.
2. Bad Business Plan
Beware of a business plan that is not understandable or is unprofitable. This could be caused by products or services that have become outdated. Technological obsolescence is a common misfortune of many business plans.
3. Poor Management
Poor management can sink almost any company. If management is selling stock, giving guidance that is untrustworthy, or cutting the dividend; beware. These would be signs of a possible value trap.
4. Complicated Accounting
Producing complicated or fraudulent company accounting reports many times means there is additional hidden problems. This usually results in further declines in the stock price.
5. Too Much Debt
A highly leveraged company has less leeway for making mistakes or overcoming obstacles. Liquidity is often a major problem for troubled companies.
6. Lacks Sustainable Competitive Advantages
A company that lacks sustainable competitive advantages to overcome tough competition or heavy regulations can lose their ability to compete.
Value Trap or Real Value Stock?
I warned in the first sentence that it not easy to determine the difference between a real value stock and a value trap. Even the best value investors buy value traps. Making mistakes is a part of investing risk. The idea is to maximize your purchase of real value stocks, and minimize buying value traps.
Related Reading: Investment Decisions Should Be Based On Valuation