Is A Stock A Real Value Or A Value Trap? How To Tell The Difference
For value investors, the market’s decline that started in April would seem to provide a prime opportunity to pick up shares of companies at a dramatic discount. While that is certainly the case with a few securities, unlike what was seen during the financial crisis, where valuations on stocks fell to a twenty-year low, it can be surprisingly difficult to find real value in today’s market.
Masking the fact that the market is approaching bear market territory – defined as a decline of 20% – is the seemingly never ending daily market swings of 4%. These fluctuations have served to make the market feel a lot scarier than it has actually been.
While in early October, the Standard & Poor’s 500 closed as low as 19% off of the highs seen in April, during the financial crisis, and ensuing panic, stocks declined by 57%.
While investors look to shares prices to determine how expensive or inexpensive the shares are, this can prove to be a mistake, as not all shares that have been beaten down by the market are real bargains, but could in fact prove to be what is known in the world of investing as value traps.
What Is A Value Trap?
It is all too easy for investors of all levels to fall into a value trap, as these securities can be difficult to spot. A value trap is the purchasing of shares in a company that has been badly beaten down in the market under the assumption that they are a “bargain”, and are not likely to fall further.
With a security that is a value trap, investors are lured in by stocks that have experienced a dramatic decline in share price thinking that they have found a bargain, only to have the share price fall even further. This is referred to as a value trap due to the belief by the investor that they are getting a great company for a low price.
The problem with investing in a company that is experiencing a rapid decline in share price is that it is a lot like attempting to “catch a falling knife”. This old investing adage simply means that an investor should not put money into a stock who’s price is likely to fall further, but should wait until the stock price has hit rock bottom – or until the knife has “hit the floor”.
Many times, value traps are companies that have been formerly loved by investors, or used to be a top company in its field and now seems to be cheap and pulls investors in. These value traps can prove to be extremely detrimental to your portfolio, and can cause massive investment losses.
Avoiding The Value Trap
So how can you determine whether a stock is an amazing value stock, or a value trap? Value stocks are shares of blue chip companies that have experienced a decline in share price, but are otherwise in good health (think of companies who’s share prices decline due to indiscriminate broad market sell offs).
While these companies typically generate smaller returns than growth stocks, their performance is fairly predictable, and many of these types of securities pay investors dividends.
The key to avoiding a value trap is to look beyond a company’s share price, to the underlying fundamentals of the business. Although two companies may be in the same sector, provide the exact same goods or services, and trade within a few dollars of each other, the fundamentals could indicate that one is actually considerably less expensive than the other.
Evaluating a security based on price alone will not tell you the whole story of what the shares are really worth. A stock that is trading at $40 a share could be undervalued based on the company’s fundamentals, while a security that appears to be the same that is trading at $30 could represent a valuation that is far too high.
A stock’s price simply represents the number the market has placed on a security so buyers and sellers can efficiently do business, and there are several other valuation methods you should be using to value a stock. Some of these methods include price-to-book, dividend yield, price-to-sales, forward earnings, trailing earnings, and free cash flow.
It is also important to understand that the primary difference between value stocks and a value trap is that a value stock will eventually reverse course and rise in price. The value stock will be propelled upwards by positive indicators such as insider buying, new products, or good earnings.
With a value trap there will be none of those positive indicators. In fact, some tell-tale signs of a value trap is the sale of company shares by corporate executives, high debt, excessive dividend payouts, poor cash flow or a combination of these factors.
That is why it is important to do due diligence on every potential investment, regardless of whether it seems on the surface to be a screaming “buy”. Only by looking into the fundamentals of a company can you determine whether it is truly a value, or a value trap.