How To Identify Value Traps

June 20, 2017

How To Identify Value Traps

  • Value stocks are tempting, but the vast majority turn out to be value traps.
  • There are a few things to look at that lower the probability of getting caught in a value trap.

Introduction

Everybody has been talking for the last few days about Amazon’s (NASDAQ: AMZN) buyout of Whole Foods (NASDAQ: WFM), and the negative repercussions that purchase had on competitors like Wal-Mart (NYSE: WMT), Target (NYSE: TGT), Costco (NASDAQ: COST), and Kroger (NYSE: KR).

KR fared terribly last week as it fell 19.2% on Thursday when its management announced weaker guidance on lower prices with the aim of keeping and attracting more customers, and another 9.5% on Friday when AMZN became direct competition. KR’s total fall in two days was a staggering 26.2%. It’s lowest point on Friday was $20.46 and the stock closed at $22.29.


Figure 1: KR’s weekly drop. Source: Bloomberg.

Those who bought on Friday are probably value investors who see a price earnings ratio (P/E) of 10 and consider the stock incredibly cheap. I don’t know whether KR or any other grocer is a bargain or a value trap, but I find this an excellent environment to discuss value traps and how to spot them to avoid them.

What Is A Value Trap?

Value investing looks for stocks that are worth more than what you pay for them, and are thus considered a bargain. This could be due to a low P/E ratio—like KR’s is when compared to the market,—a low price to book ratio, or a high dividend yield. A value investor hopes to make a profit when the market recognizes its mistake and fairly values the company again.

However, buying a stock just because it looks cheap or has fallen significantly is risky because there is usually a good reason why the stock is a bargain. When there is such a reason, the stock’s price might never recover because of intensified competition, lack of growth, management issues, or sector weakness. When the stock doesn’t recover, it becomes an obvious value trap.

How To Avoid Value Traps

This is easier said than done, but it’s important to discuss as owning a value trap might lock up precious capital for long periods of time and have a huge opportunity cost for your portfolio. Some issues that create a value trap are the following:

Lack Of Future Catalysts

What’s going to push KR’s stock price up? Well, it could be higher earnings or someone telling Wall Street that AMZN isn’t such a threat. However, given that the management recently announced lowering prices to keep customers, there is a high probability that KR’s margins will get squeezed. On top of it, as KR is highly leveraged, even a little impact on revenue will have a huge impact on net income. Thus, unless KR manages to make a turnaround, the low P/E ratio that looks attractive at the moment could soon deteriorate and create a value trap.

On top of the AMZN threat, Aldi and Lidl, two big German discounters that have roiled the grocery environment in Europe, have announced their expansion plans to the U.S. Aldi plans to open 900 stores and bring its store count to 2,000, while Lidl promises 50% cheaper goods than what other grocers offer.

A clear example of a stock that had future catalysts is Apple (NASDAQ: AAPL). We all know that there will always be a new iPhone and who knows how many other products. Thus, when AAPL was trading at a P/E ratio of 10 and below $100, there was a higher probability that it was a bargain rather than a value trap because of upcoming catalysts.


Figure 2: AAPL’s iPhone, iWatch cycles as stock price catalysts. Source: Nasdaq.

So always look ahead for what could happen to send the price higher of a stock, or at least improve fundamentals.

Sector Environment – Secular Decline

Apart from a lack of future company catalysts, it’s very important to look at what is going on in the sector and the general outlook for the product.

Many considered oil stocks a bargain when oil prices dropped from above $100 to $80 in 2014. However, oil prices continued to drop and went to $30 only to slowly recover to $45 per barrel.


Figure 3: Oil prices didn’t recover to previous highs. Source: Bloomberg.

So it’s extremely important to analyze the supply and demand forces affecting a sector. The fact that, thanks to new technologies, there is enough oil for several generations that can be extracted at low cost is a clear sign that makes oil investments a potential value trap, especially as we don’t yet know at what speed the world will shift toward electric vehicles.

When there is a bargain in a growing sector or one with a high moat business, then the likelihood of the stock being a value trap is much lower as sooner or later, the environment will change for the company. If the company operates in a highly competitive sector that is in a secular downtrend, then the likelihood of it being a value trap is much higher.

Significant Insider Activity

When a stock price drops and insiders are buying, especially middle management, it’s a clear signal that the employees have faith in the company. However, when there is much more selling than buying, it could be a signal that things in the company aren’t good at all and there is a reason behind the price drop.

Check The Sustainability Of The Dividend

If the price of the item the company is selling drops, it’s clear that there won’t be enough cash flow to continue paying the same dividend. For example, Exxon Mobil (NYSE: XOM) has been increasing its dividend payments in the last few years but its pay-out ratio in relation to earnings went from an average of 25% before 2014 to the current 125%. It’s impossible for a company to pay out higher dividends than what its earnings are for a longer period of time, thus it’s wise to be careful with such companies.

Determining Investors’ Pessimism

Behavioral finance is always helpful when assessing an investment. If a stock price has dropped for no obvious reason while the fundamentals remained the same or even improved, we might be looking at a bargain.

Sometimes investors sell a stock just because it’s in a specific country or sector without understanding what the company’s individual position is. After 2015, many sold all their Chinese stocks and Chinese stocks are still very cheap. Many of them are definitely value traps, but some are real bargain gems. In 2009, all stocks were cheap because investors were selling in panic no matter the price.

Look At The Quality Of The Assets On The Balance Sheet

It’s extremely important not to take the numbers on a balance sheet for granted and look at what’s beyond the number. For example, a piece of highly sought after real estate in New York will probably be valued more than its cost if it was bought in 1994 and still held at cost on the balance sheet. However, a mall built in 2007 in a city that’s losing inhabitants might be valued much lower than what the balance sheet says.

Up until 2015, Shell had spent more than $7 billion on exploring the Arctic for oil. However as oil prices fell, the $7 billion on its balance sheet as reserves and capitalized expenses was worthless.


Figure 4: Shell’s Arctic experiment. Source: Guardian.

Conclusion

Value investments are always tempting as the high dividend yields, and low price to book values attract investors hoping that those indicators will revert to the market’s mean. However, the large majority of apparent bargains eventually become value traps. Therefore, it’s extremely important to know what to look at and really not be afraid to say no to many opportunities, no matter how attractive they might look if the above criteria aren’t met.

Thus we’re looking at a bargain when the company has great fundamentals, operates in a growth sector with a large moat, there are many possible catalysts lying ahead, the competition is weak, the quality of the assets on the balance sheet is real and strong, the dividend is easily sustainable, and the current price is low due to reasons not related to the company or its business environment.

By Sven Carlin Investiv Daily Stocks Value Traps Share: