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Cheaper isn't Always Better: How to Avoid the Stock Value Trap

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The term “value trap” refers to a stock that has a low valuation in terms of classic fundamental metrics such as the price-to-earnings (p/e) ratio, pays a high dividend, yet is a poor investment that underperforms the market and is “dead money.”

To understand value traps, investors should consider the old saying, “You get what you pay for.” Though my mother always taught me to be frugal as a kid, she also emphasized that I should not be cheap. For example, if you buy nice clothing made from better material, you will take care of it, enjoy it more, and it will last longer. The same applies to the stock market because, often, cheaper is not better.


What are the Signs of a Value Trap?

To understand value traps, I will break down some classic signs cover some examples to prove my points.


1. “Cheap” Valuation

As I mentioned, value traps are cheap based on traditional metrics, such as price-to-earnings, price-to-sales, or price-to-book ratios. However, investors need to understand that a low valuation is not bearish but it is not necessarily bullish either. Like most investing metrics, context matters.

For example, telecom giant AT&T ((T - Free Report) ) has a valuation of 7.75, which is roughly a third of the S&P 500 Index’s 24.4 P/E.

Zacks Investment Research
Image Source: Zacks Investment Research

Despite the low p/e (which has been lower than the S&P 500 for years), AT&T is down 25%, while the S&P 500 is up 25% over the past five years.


2. Stagnant Earnings Growth

If AT&T is so cheap, then why are shares underperforming? The answer lies in slowing earnings growth. AT&T’s quarterly EPS was as high as $0.90 in 2019 but it has steadily declined to $0.55 last quarter.

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Image Source: Zacks Investment Research



3. Industry out of Favor

A stock’s industry group plays a critical role in its performance. AT&T is not the only stock performing poorly in the communications industry; Charter Communications ((CHTR - Free Report) ) and Verizon ((VZ - Free Report) ) have also performed poorly. Investors should seek disruptors and avoid legacy industries. For example, Advanced Micro Devices ((AMD - Free Report) ), a beneficiary of the artificial intelligence (AI) revolution, grew earnings by 159% last quarter. Amateur investors must learn that Institutional investors will pay a premium for growth, especially in bull markets.


4. A High Dividend Yield is a Trade Off

New, inexperienced investors often get sucked into buying a stock because it has a high dividend. Pharmacy company Walgreens Boots Alliance ((WBA - Free Report) ) is a perfect example of why a high dividend does not ensure “safety” or steadiness in a stock. WBA pays a juicy 6% dividend, yet shares are down 46% over the past year!

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Image Source: Zacks Investment Research


5. Caretaker Management

Investors must be vigilant regarding new management teams. All else equal, founder-led companies perform well until the founder leaves, and usually stagnate after. That’s because founders have “skin in the game” and are not afraid to take risks. Conversely, when a new CEO takes over an existing and successful company, their mindset tends to shift from growth-oriented to capital preservation-focused (or what I call caretaker management).

Apple ((AAPL - Free Report) ) is a current example of caretaker management. With Steve Jobs at the helm, the Apple team was expected to innovate, speed up growth, and launch new products. Meanwhile, with Tim Cook as CEO of Apple, innovation has slowed, and capital preservation has become the goal. For instance, instead of trying to break into the EV market, Cook decided to sunset Apple’s EV program. Instead, the company is hoarding cash and buying back AAPL shares in an attempt to prop them up.


GARP: A Happy Medium

The goal of this commentary is not to make investors avoid valuation at all but rather approach it in an intelligently. One method of doing this is to take a GARP (Growth at a Reasonable Price Approach). In this method, investors seek moderate growth (low double digits), with a reasonable p/e.


Value Trap Caveat: Brutal Bear Markets

Buying value traps in a bull market is a sure-fire way to underperform. However, a bear market environment (which I define as the S&P below the 200-day) is a time when investors seek stability and cash-rich companies like Verizon or AT&T. As a result, investors must understand how to diagnose the market’s health.


Bottom Line

Cheap valuations do not automatically make a stock a “value proposition.” In fact, investors who chase low valuation stocks will often get caught in value traps and underperform the market.

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