Beware of value traps! Learn how to identify the warning signs of value traps when investing in shares.
What is a Value Trap?
A value trap is a stock that is bought cheap gets cheaper… and cheaper. A stock appears to be cheap but in reality the deteriorating price is a warning of changed business fundamentals and can indicate further deterioration.
Value Trap Indicators
- Business plan changes, over complexity or failures blaming everything and everyone except themselves.
- Unprofitable expansions into non-key competency / non-synergistic areas.
- Insider selling knowing bad news before it becomes public.
- Overly high compensation for managers affecting company profitability.
- Little value being delivered for expansion or to stakeholders.
- Fintech disruptions.
- Product/service becoming obsolete/outdated.
- Non-monopoly products/services being replaced by a better performing competitor.
- High amount of cash but low interest income.
- Frequent rights issues raising capital for non-legit reasons.
- Shares buybacks, often at high prices, camouflaging company earnings and other issues.
- Fraud, legal issues, or massive fines causing a dent on the company’s reputation and profits.
One Off Items
- A large one time gain (or impairment) skewing the numbers for a quarter or financial year.
- Not sustainable long-term advantages.
- Overly high amount of borrowings causing the company to bleed paying just the interest on debt.
- When a downturn (eventually) happens, will be one of the first casualties.
- Overly high competition eroding profitability.
- Frequently in industries with low barriers to entry and little product differentiation.
- Affected by competitors who can produce in significantly larger quantities at cut-throat margins.