Right now, in the market, there are hundreds of what many value investors would call "bargains." By this I mean traditional value investments, which are trading at a low ratio of earnings or price compared to book value. However, while many of these stocks look cheap, many of them are also value traps.
To make money in the stock market, investors need to avoid value traps, which can be very costly both in terms of money invested and opportunity cost. Unfortunately, it is impossible to avoid these companies entirely. Every value investor, myself included, will have stories about value traps.
With that in mind, let's take a look at some of the qualities that traditionally mark value traps and how investors can avoid falling into these holes while looking for bargains today.
Hunting for value traps
As noted above, it is impossible to identify all value traps correctly. We will never get to the stage where there will be a big red flag by a ticker if the stock falls into this bucket.
However, from my experience, two main red flags tend to indicate whether or not a business is a value trap.
First, investors need to ask if the company in question is suffering from a cyclical or structural downturn.
For example, the newspaper industry is suffering a structural decline. The internet has made it easier for consumers to get news online, and the quality of average papers has declined. Some companies will survive, and these businesses may prosper. But many others will fail. Picking winners in the newspaper industry is going to be difficult because the whole industry is suffering.
On the other hand, steel and manufacturing businesses are much more cyclical. The world will always need steel, and there will always be a need for manufacturing (although some sectors within the manufacturing industry may not fare as well).
The outlook for cyclical businesses is easier to predict. We can expect that earnings for a cyclical business will recover in an upturn, which should generate an uplift in the share price. Of course, it will vary from company to company. A poorly managed cyclical business can be an even worse investment than a company in a sector suffering from structural decline.
This brings me onto my second major red flag that could indicate a value trap: debt. Excessive borrowing levels are by far and away the most prominent reason why companies and individuals get into trouble financially.
When times are good, high levels of debt generally do not present a problem. If a company is reporting growing earnings and a bright look, more often than not, creditors are happy to extend credit terms and provide more capital if asked.
When the outlook changes, however, the situation can change very quickly. The big problem investors face is knowing when the wind is about to change. If we knew when sentiment would change, it would be easy to sell an overleveraged business before it got into trouble.
Unfortunately, this is impossible. That's why it's better to avoid these companies altogether. It is always going to be impossible to tell what's just around the corner. That's why it's always sensible to prepare for the worst.
The bottom line
Putting the two red flags described above together gives a rough idea of the sorts of companies that might be value traps.
Companies suffering from structural decline and cyclical businesses with too much debt in particular should be avoided.
On the other hand, cyclical companies with clean balance sheets that look cheap compared to pre-crisis earnings may be good investments in the current environment.
Read more here:
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