Education: Value Investing

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Avoiding Value Traps

A company has experienced a large drop in its share price. The stock is reaching lows that have not been seen in more than a decade. Is this a buying opportunity for value investors or should they just stay away? It is imperative that “value traps” be avoided if at all possible.

Value Traps Defined

Value investors are on the hunt for stocks that are currently selling below their intrinsic value. However, when an investor purchases a stock that has experienced large price depreciation, which is mistaken to be a value stock, only to watch the price plummet further, that investor has stepped smack dab in the middle of a value trap. Unfortunately, many investors mistake a “cheap stock” for one selling below its fair value and ride the stock down to the bottom. Not every stock that has declined significantly in price is a good value.

Areas to Investigate

Those investors considering only a stock’s current price, relative to its historical price, are the ones tempting the jaws of the value trap. It would be in your best interest to look into a few other areas, such as:

Management/Leadership

An effective management team is imperative for a company to succeed. They should have a proven, demonstrable record of achievement. They are in charge of keeping the company moving in a favorable direction and to help right the ship when the need arises. Good management is contagious—it will rub off on to employees. They are the ones that set the tone for the company and strive to tackle the mission statement heads on.

Most importantly, does management care? If they don’t, the company will suffer as a result. If the company has been struggling for quite some time, and the same management team is behind the wheel, a red flag should immediately go up. If a new management team has just taken over, one that has succeeded elsewhere, perhaps they can turn the place around.

Products/Services

Does the company have a tangible, relatively fresh line of products and services? Can they easily be replicated by other companies or has this company developed something special? Are they a necessity? Has demand increased or decreased over the years? A company with a stale product line, for which demand has suffered, will see its share price suffer as a result. Beware these companies.

Debt Level

If a company already has a substantial amount of debt, and has been adding to it, this can be a bad sign. High levels of debt will be a hindrance to generating future cash. If the company has a solid plan in place to repay the debt, then so be it. The plan should include how it will be repaid and how long the process will take. It would be to your benefit to compare the company’s debt/equity level to the industry average. This will give you a good idea how it stands in relation to its peers.

Industry

Does the company participate in a favorable industry with encouraging growth prospects? Or will it struggle due to various economic factors (interest rates, oil prices, etc.)? Are there barriers to entry? If a company’s price has been beaten down this may be due to a poor outlook for its industry or perhaps it is too easy for others to enter.

Earnings Estimate Revisions

Earnings estimates are the single best gauge of the future prospects of a company. Companies experiencing upward estimate revisions will typically enjoy positive price appreciation going forward. Rarely will a stock suffer a significant price decline in the face of improving fundamentals. On the contrary, those with declining earnings estimates tend to continue their downward spiral for quite some time. Lucky for you, the best way to harness this phenomenon is through the Zacks Rank. Learn more about the Zacks Rank

Conclusion

The point here is that value investors should not buy stocks just because they are currently selling at a low price. They may be selling at a discount to their fair value for numerous reasons—red-flag reasons. However, if its fundamentals look good and the growth prospects are favorable, you may just have found a hidden gem and sidestepped the value trap. Don’t look back; it will catch the next victim.