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Thursday, August 29, 2019

How to Know Whether a Stock is a Value Trap & How to Avoid Them

Value Investing is an investing strategy and method that was taught and inspired by Benjamin Graham. Benjamin Graham is the author of “The Intelligent Investor” and considered as the father of value investing. The basic concept of value investing is pretty straight forward and pretty simple to be comprehended. The stock market is a place where many listed companies are available to be purchased or sold. Companies’ stock prices changes every day and it’s very liquid meaning that you are able to sell or buy the stock at any given time (during opening market). The strategy of value investing is to invest in stocks where the companies’ fundamental are trading in the stock market less than their intrinsic value. It’s similar like buying a Television set on sale, and knowing the price of the TV is supposedly worth more than its usual price. You’ll probably wait before purchasing because you know that there will always be times when the item is on sales. When the time comes, you’ll buy that certain merchandise at a discount getting a great value for your money. Many great value investors have made fortune in investing using this technique. Warren Buffett, Peter Lynch, David Dodd, Charlie Munger, Joel Greenblatt, David Einhorn and many more are some examples of successful value investors. 

I myself have been using this strategy in investing in the stock market and made pretty good return since I initiated this blog. Looking at companies’ financial metrics gives me the advantage of purchasing a stock that is on discount. However, there is a challenge when investing using this value investment strategy. It’s not as simple as you would think to be and this is where the term value trap comes in. Value trap is a stock that appears to be cheap having low valuation financial metrics such as multiple of earnings, cash flow or book value for an extended time period. Such stocks of course attract many value investors such as myself thinking that the stock is trading at a bargain price. The trap happened when investors purchase the stock at a low price thinking they are getting a bargain but the stock continues to weaken and drop further. Its price appears to be a bargain but in fact the stock is not selling below its intrinsic value. This of course results for the investors that purchase that particular stock to lose money on their investment. I myself experienced value trap when investing in the stock market. It result me losing approximately $40,000 on that stock (Ticker: GME). After going through this horrible mistake, it made me become more experience in investing in the stock market and be more cautious when investing. So how do we spot a stock that is a potential value trap? In this article, I will explain my experience and knowledge to know whether a stock is value trap.

Check the Company Earnings and Cash Flow
If a stock’s price is trading at a cheap price compared to their past earnings, this could be a warning for you. Be aware, that past earnings don’t guarantee that the company will continue to provide the same earnings in the future. When I invested in Game Stop Inc. (Ticker: GME), I was too fascinated with its past earnings performance and the stock looks cheap when analyzing the stock with the financial metrics to value a stock. I was already aware that the company is going through some problems in the future since the gaming industry is changing drastically. However, I ignore the business future and thought that the company was a bargain without realizing that the company was actually a value trap. From this harsh lesson, I realize that when a company is trading at absurdly cheap compared to their past earnings is a clue that something is wrong going on with the company business. 

Dividend Yield is Too High
I’m a dividend growth and value investor, and seeing a company paying a high dividend yield and low valuations attracts me to invest in the company. However, from my experience with Game Stop Inc. (Ticker: GME), I learned that the High Yield that Game Stop Inc. was paying was not sustainable. When I started investing in the company, the stock was yielding me dividend of 8%. The stocks however tumbled, and I still maintain the stock thinking that the company can continue paying me the high dividend I’m receiving. I thought that the company could turn around since the valuation looks cheap. But that was not the case, the stock eventually decided to stop its dividend payment, and the stock deep even further. Since I’m a dividend growth investor, I needed to hold companies that are paying dividends. But my Game Stop Inc. investment doesn’t pay the dividend I wanted, so this result having to sell the stock at a realized lost. I was horrified with this stock pick thinking that the investment was a bargain. From this lesson, I learned that when a company is paying dividend above 7% or 8%, the odds are you’re not necessarily going to get that. Some of those companies are going to cut their dividends or even worst eliminate it. Remember to analyze the companies’ dividend payout ratio. Seeing that ratio let you know how much of company’s earnings are being paid out as dividends. When you see the dividend payout ratio is high (anything above 1.00), that is usually a bad signal for the company being able to pay its dividends from their future earnings. A high payout ratio can lead the company’s dividend exposed to a decline in earnings. I recommend finding a dividend paying stock that have a dividend payout ratio below 0.60. This shows that the company is able to sustain paying its dividend. But remember if the company’s future business is in huge decline like my Game Stop Inc. investment, it’s better to avoid investing in that company. Remember, past ratios don’t always guarantee that the fundamental of the business can’t change in the future. 

Business Getting Outdated
A company whose business plan is outdated by new technologies is usually a bad investment. Game Stop Inc. was the stock that is going through difficulty adjusting to the way consumers are changing trend of purchasing their games through digital distribution such as Steam. People were not purchasing games through retail stores like Game Stop Inc. since it’s much simpler to purchase game through the internet. Not only that, people are also moving trend to mobile gaming (smartphones) which games are purchased through application stores on their smart phones. Game Stop Inc. story is similar to a company called Blockbuster LLC that went bankrupt. Blockbuster was a company that provide home movies rental through a video rental shop. People were not using their service since consumers are switching to the way they watch movies. They were using services such as Netflix, Hulu, any many other video internet sources online. Their business model is outdated and not much change can be applied to restore their business strategy. Moreover, I also want to mention an experience I went through during my investing horizon. Do you remember a mobile phone called Blackberry. Those phones were hot selling products and the company made a lot of money, however after the rise of Apple and other Android products, they were not able to compete. This is a good example of a value trap stock. At the time when the stock decline, the stock’s valuation looks attractive since their past earnings were high. However, they were not able to continue their business operation because consumers are not purchasing their products anymore. And as of today, I think Blackberry is just a history of a device that many were using back then. So remember before investing, besides looking at financial metrics, you’ll need to understand whether the company is able to do business decades ahead.

Poor Management and Business Plan
Poor management can destroy almost any company. If you encounter a company whose managements are selling their stock away, giving guidance that is impossible, or cutting the dividends; these are signs of a possible value trap. Before you invest, look at the company’s management. Check what managements are doing with their own shares whether they are purchasing or selling. When managements are selling their own shares in the company can indicate they have no confident in the business. However, if they are purchasing shares in the company that can indicate a positive sign that they are confident with the business they are working in. Great management will give trustworthy guidance and able to show the knowledge how their business plans will be successful.

A company that lacks of business plan can face challenges ahead and loses their ability to compete. In today’s cutthroat global market, a company needs to have a good business plan to stay competitive. Before you start investing, make sure that the company has great strategic business plan that will provide the cash flow and growth in order to stay afloat. In addition, see if the company is market leader, have economic of scale, pricing power, differentiation of products, cost benefits, or powerful brand. Without one or more competitive advantages the company may not be a good investment.

Also be aware of companies that business plan is difficult for you to understand. Warren Buffett’s investment success is because he was able to understand the business he invests in. He avoids companies that he has no understanding or knowledge in. For example, even when everyone knows Microsoft Corporation (MSFT) is a great company, Warren Buffett avoid investing in that business since he has no clue how the business operates. Even his own close friend, Bill Gates the founder of Microsoft wasn’t able to persuade Warren to invest in Microsoft. This shows Warren Buffett’s investing principle that enables him to become successful.

Complicated Financial Accounting Report
When a company produce complicated or fraudulent accounting reports often means that there are additional hidden problem with the company. If you encounter any hint of fraud in the company, you should stay away from investing in the company. An example of a company that went bankrupt because of accounting fraud was Enron Corp. The company was trading in high $90.75 per share in the mid-2000, by November 2001; the company was trading less than $1 a share. Eventually by December 2, 2001, the company filed for bankruptcy under Chapter 11. It was mentioned that the company’s balance sheet was difficult for analyst to even understand. If you have trouble understanding the company financial report, this is a sign of value trap. It’s better to stay away from trouble than losing your hard earned money. Real value investments will have simple and transparent financial reports and credibility with investors. Great quality companies with honest management will demonstrate openness and integrity with their success and failures. This will give straightforward understanding for investors who want to invest in the company.

In addition, the balance sheet may be more important than the income statement. Check the companies’ balance sheet before investing. If you see a company that has high debt shows that there will problem with liquidity and solvency even when the company has a good business plan. A highly leverage company has a harder time if they make mistakes or overcoming problems. A strong balance sheet is foundation of a great quality stock you want to invest in because it provides a margin of safety. When companies with strong balance sheet encounter disadvantageous condition, it is able to have financial flexibility to meet these challenges.

Look Forwards Instead of the Past
Last but not least is to always remember to look at the companies’ future business. A stock might look cheap when comparing to its past earnings, but forward earnings is what matters the most. If a company has great earnings in the past that don’t determine that it will do so in the future. I know that looking at the companies’ past financial performance can give you a better understanding of how the company is doing. However, when a company is not able to perform well in the future, it will affect the value of the company. Most financial websites shows only ratios based on their past earnings. So it’s best if you also calculate the company’s forward earnings and cash flows metrics to the current price. That way you can have a better understanding how the company will perform towards the future. As a dividend growth and value investor, I always want to invest in companies that are performing towards the future. That way, I can hold these great companies that pay dividends now and even towards the futures.

In Summary
After reading this article, you readers probably understand the financial term of a value trap. As value investors, you not only want to buy stocks at a bargain but to be aware that you are not investing in companies that have potential of declining further. I hope you readers understand how to avoid value traps companies when investing in the stock market. Always remember factoring companies’ balance sheet and future prospect before investing. Make sure that you are able to understand the business model and how the management is operating the company. Moreover, make sure the companies you want to invest in stays competitive and business that are not going outdated. You don’t want to make the same mistake I made with my Game Stop Inc. investment. I lost a huge sum of money because I was invested in a company that was a value trap instead of a hidden gem. I don’t want this tragic moment to happen to you readers out there. Last but not least is to always remember in order to be a great investor, you should not rely on past financial performance but how the company is going to perform in the future. After writing this article, it has helped me understand more about value investing philosophy and to be more cautious before I invest in a stock. There are many challenges to become a successful value investor. But by sharing my knowledge and experience in the stock investing, not only aids you readers become a better value investor but also help me to become one as well.


  1. Hello! You formulated the concept of trap very well. I like reading articles like this because it helps me develop my portfolio. Looking forward to your next post.

    1. Thanks for reading my article. I hope the content I wrote can help you out.

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