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Value Trap: How to Separate the Wheat from the Chaff?

Created on 02 Jul 2021

Wraps up in 6 Min

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Updated on 11 Sep 2022

Warren Buffett succinctly notes, “Price is what you pay. Value is what you get.” But wait, what if the seemingly underpriced stock is a Value Trap? Here’s how you can tell...

The world has changed dramatically in the last few decades. There have been multiple economic cycles, technological up-gradation & regulatory changes which have affected many corporations and industries. With the change in time and market conditions, the stock market has also evolved and adopted many new practices such as digitizing financial reporting, introducing low-cost passive investments, and the new era of high-frequency Algo trading.

However, the one practice which got its roots in the mid-90s and is still admired by many savvy investors is the “Principle of Value Investing". Indeed the strategy has proven to be a success key for many big investors. But it also comes with one of the biggest risks. And what’s that, you ask?

Value Traps

Value Trap, in market parlance, is when an underpriced deal turns against the investor’s expectations.

Well, here's some context. Apart from the fundamental factors, a stock buying decision is generally driven by a low P/E or P/B multiple, negative enterprise value, or an excellent dividend yield.

Undoubtedly, these are universally used parameters, and a stock with these attributes can deliver significant upside, but what if these low valuations are not the result of market inefficiencies and are instead caused by some long-term or more permanent factors? In short, how can you tell if it’s a value trap?

How to identify Value Traps?

There are no set of hard and fast rules or formulas that would help you avoid value traps. But, one can follow some basic due diligence to identify them:

  • Economic Moat

A sustainable economic moat ensures that the company thrives in today's competitive environment. But if the company does not have any competitive strength or loses its competitive edge, it will surely struggle to maintain its margins and market share.

Take the example of IRCTC, which enjoys an absolute monopoly in e-ticketing and packaged water distribution in railway stations. Imagine the government allows private companies to enter this space and the company's monopoly vanishes. If this situation occurs, there are high probabilities that IRCTC will lose its market share, and thus the market may not give it the same valuation multiple which it is getting now.

In such a scenario, the stock prices would seem bargain if you compare it with its historical average but might not be able to recover from whatever caused the stock to become undervalued. Certain types of structural changes in technology, regulation, or customer demand can permanently affect the business fundamentals, which is where investors need to be careful.

  • Earning Trend

This is one of the most critical aspects which many investors forget to consider. A stock with a low P/E multiple compared to the industry average might seem a bargain at a superficial glance. Still, a deeper analysis would detect that they become substantially riskier if you factor in the future growth prospect. As it is said that stock prices are slaves to earnings, it is the profit growth of a company that drives stocks to appreciate.

  • Cyclicality

Certain industries are highly sensitive to the business cycle, such that revenues and earnings are higher in periods of economic prosperity and lower during economic downturns. These companies typically look cheap in an upcycle due to higher earnings, but before you rush to buy these so-called ‘attractive gems’, you need to check what might be around the corner.

There are possibilities that the cycle is going to turn, and the industry may approach a slowdown. One can easily detect this by looking at the historical price & valuation chart. If the lower valuation is due to cyclicality in the business, there would have been a similar pattern in the past.

  • Accounting issues

Despite having good revenue and profit growth, certain companies do not get a good valuation multiple. Many investors easily fall prey to these deals because this is not the case of the wrong metric used; rather, it is due to manipulation in the financial reporting by the company's management.

Hence, investors need to analyze the numbers closely and from different angles. If there is any unusual revenue or profit growth compared to the industry trend, then one reason could be accounting manipulation. 

  • Debt

Debt in the balance sheet and market valuation of a company has a close link. No matter how good the management team, product, or service offering is, the market does not favor a debt-laden company due to its vulnerability to solvency risk.

Recently we have seen many examples of big companies like Reliance Industries and Tata Motors, where value unlocking started only after the company announced its plan to deleverage the balance sheet. Although debt financing is not always a red flag, special attention should be given to the company's ability to pay the debt. Many promising ventures such as Videocon, Kingfisher, Essel group have lost their grip due to high debt in the capital structure. 

  • Asset Quality

This is one of the most important indicators for a deadly value trap available in the Banking and Financial Industry. Investors need to be double careful, particularly in the case of PSU Banks, whose valuation may appear to be mouthwatering but can be a potential wealth destroyer.

No doubt that the Price to book value ratio is still a solid measure to value banking companies, but the prevailing asset quality and ROE should be given special attention to analyzing the full picture. 

  • Capital Allocation

Surprisingly often, companies with solid cash in the book fail to get a premium price tag. But one needs to remember that the market always sees the future and if the future prospects are gloomy, the valuation gap will widen more & more. If the management has a history of poor capital allocation, a high dividend yield or a hefty free cash flow may not support the price appreciation. 

Should you buy stocks at their 52-week low price?

We all aim at maximizing our return on investments by buying at low and selling it at a higher price. One of the popular methods to do so is by filtering 52 -week low stocks.

However, this can take you straight to a value trap if you miss considering the reason behind the fall. When a stock falls by 20-30% or hits its 52-week low level, it does not mean that the prices have bottomed out or are ready to rebound.

The first thing to see is whether the fall was due to any short-term reason like temporary pessimism or whether it is the result of some fundamental change. If the reason stands out to be the former, you can add it to your watchlist for further analysis, but in the case of the 2nd scenario, where prices have fallen due to fundamental reasons, it's better to stay away.

The Bottom Line

Starting from the world’s best investors to retail investors like us, we all have made some kind of investment decision that did not work in our favor. But what gives a seasoned investor an edge over an average investor is the ability to deal with the investment mistakes proactively. To avoid committing the above errors, define the investment thesis by fundamentals and not just valuation.

As Warren Buffett says and we quote -

As Warren Buffett says and we quote - "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Usually, long-term investing decreases failure rate and reaps good returns, but only if you buy a quality business at a reasonable price and stay patient. Whereas if you invest in a value trap, your patience might just not pay off.

Invest wisely!

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Rishika Mukherjee

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Mukherjee is an avid reader and loves to write as much as read. She is the youngest of all but handles chores like a 50-year-old woman. She takes a lot on her plate and somehow, eerily manages to get the job done. As Hazel Grace stated, she could read a good author's grocery list, and so would Miss Mukherjee. 

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