Valuable Stock or Value Trap

 

"Never buy what you don’t want, because it is cheap; it will be dear to you." Thomas Jefferson 1825"

Just because a stock is down from their peak it often seems to be attractive to value investors as they might think that it might be trading below their intrinsic value but are they really?

This is the issue that lies with the value trap companies.

A value trap is a kind of a stock that appears to be undervalued based on the traditional approach towards valuation metric such as low price to equity ratio low price to book value ratio low return on equity ratio but in reality it will remain cheap or further decline for the due to the underlying fundamental issues that might be existing that might not be visible from the above.

What are the some of the characteristics of Value track stocks:

·        Low P/E ratios - Just because company’s P/E has declined or is low doesn't indicate the company would be undervalued it can also indicate the company’s ability towards future earnings specially if the company is trading lower than the industry average

·        Deteriorating Financials - If the companies operating in a highly competitive landscape it may struggle to keep up his foot to hold the market share but if the company is operating in a declining industry and is able to regain or increase the market share it's still would be a trap for investor.

·        Increasing Debt - rising level of debt can be a sign that the company is not able to manage their finances thus increasing the risk of financial instability also look at the interest service coverage ratio.

·        Competitive Landscape and Challenges - If the companies operating in a highly competitive landscape it may struggle to keep up his foot to hold the market share but if the company is operating in a declining industry and is able to regain or increase the market share it's still would be a trap for investor.

James Chanos on Value Traps

Jim Chanos is the founder and managing partner of Kynikos Associates. As the largest exclusive short selling investment firm, Kynikos provides investment management services for domestic and offshore clients. Mr. Chanos opened Kynikos Associates in 1985 to implement investment strategies he had uncovered while beginning his Wall Street career as a financial analyst with Paine Webber, Gilford Securities, and Deutsche Bank. 

"A lot of our best shorts have looked short all the way down. Just because something is cheap doesn’t make it a good value. A lot of times the company can get into distress due to a declining business. That defines a value trap.”

If you want to read more , check out What Is a “Value Trap”? - Cary Springfield

Just to sum it up just because a company is trading at or near historical lows is clearly bound to be tempting to any investor particularly with the hope that it will rebound towards the higher highs, But sometimes the reality is achieve stock can remain expensive even when the company's true value remains even lower than that is reflected in the stock price that is currently the company's trading at. During this time it is important to perform a detailed fundamental analysis of a company before investing as it will allow to determine the investor the true value of a stock that appears to be cheap on the surface during that course the investor would be able to identify the value and the price of the stock and from there he will be able to determine whether to buy or let it be.