Value Investing – How to Avoid Value Traps

In this National Post article, I explain how value investing principles can help investors avoid value traps when selecting stocks. The key is to assess whether management can execute strategy over the business cycle. The biggest mistake many value investors make is not being proactive enough in pulling the trigger on a stock that shows signs of deterioration. To view the article click here

Value Investing: What is a Value Trap?

Value investors can find a stock that appears to be a good value because it is trading at low multiples of earnings, cash flow or book value for some period of time. The stock attracts value investors who are looking for a bargain because it appears to be trading below its intrinsic value. The value trap occurs when investors buy a stock at a low price, but over time the price fails to rise. If a stock continues to trade at low multiples of earnings, cash flow or book value for long periods of time may indicate that the company or perhaps the entire sector is in trouble, and that stock’s price may not move higher.

To avoid value traps, value investors should consider the following:

  1. Avoid stocks that have dropped in price due to to exposed corporate fraud. Remember that when fraud is involved, the figures in the financial statements that are used to determine value are meaningless, and the company simply cannot be valued appropriately.
  2. Beware of overly optimistic guidance from the company’s management. A company that promises double digit earnings growth is likely being unrealistic. When management can’t deliver, they may be tempted to fabricate data.
  3. Avoid companies with high debt or leverage. Debt can be a double edged sword. When the economy is growing companies can increase earnings using leverage; in bad times, they can lose money much faster.
  4. Avoid companies that have fallen because they offer outdated products and services. Remember Blockbuster? Who needs to goes to store to get DVDs when we can download them at home with the click of mouse? Outdated products and services often signify that the lost revenues are probably lost forever, and that a rebound in the stock price is unlikely.
  5. Be careful of companies facing increasingly stiff competition. The obvious example of this is RIM. Value investors look at the profit margins over a period of 5 to 10 years, and also compare profit margins of competitors in the industry. If profit margins are decreasing through the years, the company may be unable to pass increasing costs onto its customers due to price competition.
  6. Avoid companies in highly regulated industries. High regulatory costs in Canada, the US and Europe have forced many companies to relocate their business to other countries like China.
  7. Be cautious with stocks that have dropped due to a dividend cut. Dividend cuts usually means the company has little or no earnings to pay out. The price correction following a dividend cut can be prolonged.
  8. Pay attention when companies miss earnings estimates. Analysts are generally quite lenient in their estimates and tend to revise their estimates downward before earnings releases to allow companies to beat their estimates and look good. A pattern of earning misses is foreboding.
  9. Invest in profitable businesses only. Look at the company’s income statements dating back at least five to ten years. Look for upward trend in revenue, earning and dividends. A company with consistent negative earnings every year may be too expensive at any price.
  10. Look for a healthy balance sheet. The company should have current assets greater than current liabilities, to ensure that it can pay its bills in the short term. Calculate the quick current ratio by dividing (total current assets – inventory) by total current liabilities, and make sure the ratio is greater than one. Another good measure of financial vigour is the debt to equity ratio, obtained by dividing total liabilities by total equity plus capital surplus. Debt to equity ratio should preferably be less than 1; the lower, the better.