Picking stocks is both an art and a science, and investors make mistakes. There are stocks that appear to be value opportunities, but turn out to be losing investments that drag your portfolio performance down. But how do you identify value traps?
We have the perfect guide to help investors identify value traps and the right advice on how to deal with them.
What is a value trap?
A value trap is a stock with a low valuation that might appear attractive to be an attractive investment but turns out to have a poor performance.
While undervalued stocks can be a great investment, and tend to offer a higher return than growth stocks over the long term, that does not mean that every undervalued stock is a good investment.
Although there are several ways of identifying undervalued stocks, investors are not able to always to pick the winners.
How can you identify a value trap?
There are several ways to identify value traps, and it all starts with stock due diligence. Researching every company individually is the only way to be able to differentiate between a value stock and a value trap.
Here are 7 ways to identify value traps and understand whether they are value traps or value stocks:
1. Overleveraged companies
Leverage is always a double-edged sword, and it is the best way to understand how the company is actually allocating capital. Companies that know how to allocate capital effectively will benefit from leverage because the return on their investments far outweighs the interest paid on the debt.
While stocks with overleveraged balance sheets can be attractive value investments, there are some that scream value traps.
How do you identify them? Here are a few questions that you should ask yourself if you consider investing in a value stock that has a lot of debt.
What is the equity value of the business?
Equity is an important figure because it allows you to calculate how much tangible value you are getting when you buy the stock. Although some items on the balance sheet might be overstated or understated, this has historically been one of the most used measures by value investors.
Price-to-book is nothing other than calculating the equity value of the business you are getting for the stock price you are paying. It is important to avoid companies that are overleveraged and have a negative or slightly positive equity value. This means that in the case that the company goes bankrupt, there will be nothing left for common stockholders.
How much is the interest expense?
If you find companies whose interest expense is a large percentage of their earnings or revenues this is a huge red flag. This means that there could be a future quarter where the company has negative earnings due to the amount of interest it has to pay on its debts.
Although this is typically the type of value stock you want to avoid, there is more to it. In fact, this type of overleveraged company can actually be a great performing deep value stock.
The reason is that these stocks tend to trade at very low valuations because analysts are pricing in the possibility of going belly up.
However, you need to pay attention to a few different factors:
Has the company been able to reduce or refinance its debt?
If a company has a large interest expense but has been able to refinance its debt at a lower interest, or is constantly reducing its debt, it can be an interesting investment.
If the situation improves and the company continues to reduce its debt, the stock price could push higher. There will also be fewer investors looking to hold this kind of stock, due to the higher risk that it carries.
What is the outlook for the company?
If the outlook for the company is positive, and it continues to reduce its interest expense and debt levels, then there are enough catalysts for a stock rerating. Typically these types of deep value stocks could increase between 100% and 300% over the span of a few years if everything goes according to plan.
One such example is UNFI, which was very close to being bankrupt, but the management was able to turn around the situation.
What is management doing to reduce debt?
It is also important to understand what is the management’s stance on the company’s debt. Do they mention it in the earnings call, or do they state that they want to reduce it? You want to avoid companies where management has repeatedly shown that they are not able to deploy capital profitable.
In this case where the ROIC is lower than the average interest paid on their debt.
Is the company refinancing its debt or able to borrow more money?
Refinancing always tends to be a good measure of improvement for a company that is struggling with high debts. If a company is not able to refinance its debt or borrow money, that means lenders are not willing to risk their capital, not even for a very attractive interest.
In this situation, you want to avoid these types of stock like the plague. Companies that are unable to finance their operations, and are overleveraged are value traps.
2. Declining revenue
Any company whose revenue is declining is always a bad sign. It means that the demand for their products or services is declining or they are in a shrinking market. In this type of situation, you need to understand what is driving the lower revenue figures, which usually falls upon one of these situations:
- Structural problems with the company
- Products or services losing market share
- Temporary operational problems
- Shrinking market
Structural problems with the company
If a company has structural problems, then it is always better to avoid them. This means that it could be a problem at the top level, and that management is addressing it properly. It can either be a lack of innovation, organization, or even a lack of focus.
Products or services losing market share
If the company’s products or services are not attractive anymore, it is only natural that it will lose market share. This is reflected in the revenue loss, and it can either be reverted or not. It is better to avoid companies that are losing market share, and are not innovating or improving their products or services.
Temporary operational problems
Some companies may also experience some periods of operational problems. A clear example of this is how the pandemic disrupted supply chains and ultimately affected businesses around the world. Some temporary hurdles might only affect the company for a quarter or two.
As an investor, it is your job to identify whether problems are structural or temporary. If it is a structural problem, you have probably identified a value trap. However, if the problem is temporary, it could be a great value investment.
Lastly, there is also the possibility that the industry or market where the company is present is actually shrinking. This is clearly a bad sign, and it means you should avoid these types of stocks.
Obviously, as the market continues to decrease in size, the demand for the products or services the company sells will tend to be lower and lower.
3. Shrinking margins
Shrinking margins also tend to be a good indicator to identify value traps. If a company’s margins are shrinking, that usually tends to be explained by a few factors:
- Increased competition
- Increased input costs
- Management's inability to maintain margins
When the competition in a given market increases, it is only natural that the margins of the companies in that industry tend to decline. As more competitors enter the space, they are willing to offer products or services at a lower price than their competitors.
As they gain more market share, even the well-established companies in the space might be forced to lower their prices also. In this type of situation, you need to consider the company’s moat.
For example, even if 10 different companies decide to enter the drinks market with their own version of the beloved Coca-Cola drink they would hardly gain any market share. It does not even matter whether the price of their drinks is substantially lower.
If a company has a strong competitive advantage and it is still experiencing a lot of competition, it could actually be the right investment. However, a company without a moat in a highly competitive market will most likely be a value trap.
Increased input costs
Margins may also decline due to increased input costs, which may be just temporary. If it is temporary, then it might actually be a value stock you want to consider. However, long-term raising costs could have an impact on the business and its profitability.
Once again a company with a competitive advantage will be able to adjust the pricing of its products and services to reflect the higher input costs. So, they will be able to pass these costs to consumers. But not every company will be able to do it.
Try to determine whether consumers will still buy these products and services even if they are more expensive in the future.
Management's inability to maintain margins
Shrinking margins may also reflect management’s inability to lead the company in the right way. Perhaps they are not making the right decisions, on how to deal with their competitors. In this situation, the stock seems to be a value trap you want to avoid.
4. Competitors have a wider moat
When a company does not have a competitive advantage or its competitors have a wider moat, it can also be a way to identify value traps. Without a competitive advantage, a company with a low valuation that is struggling can continue to drop in price.
As it loses market share and is forced to lower the price of its products and services, it seems only natural that the stock prices continue to drop and reflect that.
A company that does not have a moat will be forced to lower prices in order to maintain or try to gain market share. This results in lower margins, which can put the profitability of the business at risk.
5. Unable to grow organically
Some value traps can be identified as companies that are unable to grow organically. This type of business will often have to invest a lot more money in M&A, to generate the same amount of growth as other businesses growing organically.
Some of these value traps are often companies that either:
- Make a very large acquisition and overpay
- Have a hard time integrating both businesses
- Companies that merged, but are now performing poorly
M&A opens the door for mistakes, and there are plenty of things that can go wrong with this growth approach. Integrations might not work as expected and some synergies do not always materialize.
Finally, the price paid may also be higher than the value of the actual business, and this means shareholder value destruction.
6. Bad management
Every decision at a top level has a great impact on any organization, especially in companies. A value stock that has an unfitting management team could in fact be a value trap.
When you are looking for undervalued stocks, you should try to ensure that the management team shares your views and creates shareholder value. One of the ways to identify this is by hearing the earnings calls, and understanding exactly what is the management’s stance on a few key topics.
Avoid companies where the executive compensation is not justified by the company’s results.
You should also steer clear of companies whose management has proven time and time again their inability to manage the company in the right way and create shareholder value.
7. Majority shareholder
Companies with a majority shareholder can either be a blessing or a curse. It can be a blessing if the majority shareholder is aligned with minority shareholders.
However, it can also be a curse if the majority shareholder tries to take advantage of all of the other investors. This includes taking actions that end up benefiting one to the detriment of the minority shareholders.
It is important to understand the ownership structure of the company you are considering buying stock in and figure out what their views on the company are going forward.
While it may seem easy to identify value traps, the truth is that it isn’t. It depends a lot on the company itself, and a multitude of factors. In some situations, you may even find companies that seem to be in an identical situation, but one is a value stock and the other a value trap.
Picking stocks is more than just luck, and by being aware of these ways to identify value traps, you can have a better chance of picking the right stocks.
Every stock is completely different from each other, and in some cases, they can turn into high-return value stocks or value traps. Be aware of how to identify value traps, so you can avoid those bad apples.