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Value Trap – Meaning, Working & How To Avoid It?

  • Rudri Rawell
  • Jan 14 2022
  • 8 minutes
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Have you ever wondered what the true value of a share is? Is it the same as its market price at which it is traded, or are there other ways in which you can determine its true value? Before you begin investing in the stock markets, you must understand that a share fetches you an ownership in a company and therefore comes with an intrinsic value which may be different from the value at which it is being traded in the market.

Seasoned investors often prefer to invest by identifying good-quality stocks that are mostly undervalued and stay invested in such stocks for longer periods. This is mostly to ensure good returns. However, the technique of identifying undervalued stocks requires a thorough understanding of various factors that help in gauging the intrinsic or true value of a stock.

If the process of identifying undervalued stocks is not full proof, investors may end up in a value trap and their returns can be significantly impacted. So, what is a value trap and how does one know that a value trap exists?

Let’s understand the concept of value trap and how to identify them.

What is a value trap?

The concept of value trap emerges from value investing. Value investing is about picking stocks that are currently being traded at lower values as compared to their intrinsic value. These stocks have the potential to offer good returns in the long-term.

To determine a stock’s intrinsic value, an investor must know how to analyse the company fundamentals, including its financials, management efficiency, innovation, profitability, market competition, etc. 

There are many reasons why a value trap may occur while identifying value stocks and determining its intrinsic value. For instance, if a company does not prioritise research investment for new product development or innovation in services, the stock of such a company may turn into a value trap in the near to long run. While today, it may seem attractive, such investments won’t fetch expected benefits in the long run. Therefore, investors must closely consider and understand the company’s future plans.

How does a value trap work?

A value trap is when a stock’s price looks very attractive and lures investors. Investors may invest in such stocks with the understanding that these are currently undervalued and are available at a cheaper cost. Investors expect the prices of such stocks to rise in the future and thereby fetch them profits. However, the stock prices may fall and result in a loss for the investor.

Did you know?

Vodafone Idea was once a very popular and sought-after stock in India. Due to high debt and lack of innovation coupled with growing competition, the stock turned out to be a penny stock with a significant drop in its market cap in 2019. (source – https://www.ndtv.com/business/6-popular-stocks-that-turned-into-penny-stocks-2628885)

Tips to identify and avoid a value trap

If an investor invests in a stock only because the stock price has come down, it can signal danger, as such investments can often be value traps. Generally, a stock that has been trading for a long time with the company’s returns, book value or cash flow being low, shows very little prospect even if its price looks attractive. 

Here are some important clues that investors can use to spot and avoid value traps:

Analyze the competitors

When stocks are analyzed as independent assets, investors may end up in a potential value trap. It is important to compare the performance of a company with its competitors within the industry. While it is at the peak of an operational cycle, a company’s stock may grow slower than its industry competitors. Investors must, therefore, find out the specific reasons for its slow or poor performance.

Check for innovation

Innovation should be at the centre of any company that wants to stand its competition in today’s fast-paced business environment. With innovation, companies can introduce newer and better products and services to sustain competition. In the absence of new products and services, the earnings growth or momentum of growth of the company will be slower in the future. Hence, investors should avoid such investments.

Multiple share categories

Investors who own ‘Differential voting right’ shares are often insiders or large investors. Companies may ensure to keep such investors satisfied more than the ordinary shareholders. Hence, any average investor should be careful about investing in such companies that have multiple shareholder groups or categories, as it may end up being a value trap.

Management structure

A company’s earnings may be cyclical and could swing in different directions depending on its performance. In case of a drop in earnings, investors must look for a corresponding drop in the company management’s pay scales. This indicates ethical and rational response on part of the company’s management. If, however, a company’s earnings drop but the management pay scales do not align, it indicates that the company may not sustain economic downturns and end up being a value trap in the long-run.

Efficient use of capital

Often, a value trap is seen in companies that have free cash flows but may be inefficient in allocating the capital towards business growth. With a good understanding of the company and the industry, an investor can look beyond free cash flows and compare it against the competitors to avoid falling into a value trap.

Efficiency in capital usage can be determined by looking at ratios such as Return on Equity and Return on Assets. The former tells investors whether the shareholder’s equity is being appropriately utilised, while the latter tells whether a company can manage its assets appropriately.

Debt structure

If a company is utilising debt to manage its working capital requirements, investors should also check whether it is able to sustain the debt. Too high a financial leverage can signal danger and end up being a value trap. By looking at a company’s debt-to-equity ratio, an investor can know the amount of debt that the company is using as against equity. The bottom line is to look at the company’s capability to service its debt obligations. 

Conclusion

Investors who wish to fetch positive long-term returns from their investment must closely consider the stock’s valuation while weighing different factors mentioned above. It is important to know of possible value traps to avoid any significant impact on one’s investment portfolio.

Before investing in a stock, one must clearly know about the company’s business, its financials and surrounding aspects. Investing in a stock by considering it as a business partnership may fetch higher benefits rather than investing in it because of its popularity or based on investor recommendations.

FAQs

What is the margin of safety in value investing?

While identifying the intrinsic value of a stock, there are chances that an investor is overly optimistic. Margin of safety acts as a cushion by managing optimism. For example, if the intrinsic value of a stock is expected to be Rs, 100, with a margin of safety of 20% an investor can bring the value to Rs 80. This helps to avoid overpaying for an asset.

What are the important ratios used in value investing?

Price to earnings ratio and price to book value are two of the most important ratios used by investors while value investing. The former compares the company’s stock price to its earnings, while the latter compares the stock’s market value to its book value.

Which is better, value or growth investing?

Selecting between value and growth investing is entirely an investor’s choice and investment strategy. However, in the past few years, there has been a visible shift from value to growth investing, especially by investors seeking faster returns rather than very long term.

How to pick growth stocks?

Growth stocks often reflect consistent above-average earnings growth. Such stocks often lack a long history of substantial gains but carry the potential for explosive growth along with a higher risk due to higher volatility.

How does high inside ownership result in a value trap?

High inside ownership means higher chances of a single investor or entity dictating terms to the company management. This may result in operational inefficiencies and losses in the long run.

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