What is a Value Trap?

//What is a Value Trap?

What is a Value Trap?

As a self proclaimed value dividend investor I tend to read related articles, posts and books on the subject and I always see the term “value trap” but I never actually looked it up.  Upon reading a little bit of the term, it feels like I am inevitably going to fall into one day, but I am not entirely convinced it matters all that much.

What is a Value Trap?

Investopedia provides us with a pretty good definition to start with,

A stock that appears to be cheap because the stock has been trading at low multiples of earnings, cash flow or book value for an extended time period. Stock traps attract investors who are looking for a bargain because these stocks are inexpensive. The trap springs when investors buy into the company at low prices and the stock never improves. Trading that occurs at low multiples of earnings, cash flow or book value for long periods of time might indicate that the company or the entire sector is in trouble, and that stock prices may not move higher. (emphasis is mine).

The Motely fool has an expanded definition that provides a little bit more information,

A value trap masquerades as a value stock because its stock price has been beaten down. However, unlike a true value stock, a value trap’s price is low for a good reason. Investors who buy solely on stock price are likely to be caught by value traps, because it takes investigation into the fundamentals of a company and its management to determine whether a stock is a value or a value trap. Because investors buy value stocks on the assumption that they will return to their intrinsic values, investors who mistakenly buy value traps risk losing the price appreciation they were anticipating.

I am not entirely sure what “never” means for Investopeida.  Does it mean within a year? a decade? a generation?  My holding period theoretically could be forever which means that if it is an value trap for a number of years and then eventually it explodes then it doesn’t matter.  It feels like a discussion between value and stock price diverging, and if that is the case then I follow Buffett’s advice when he says to ignore the price.

Am I Destined to Fall into a Value Trap?

Every single month for the past 2 or so years, I have provided guidelines as to what I am looking for in a particular equity:

  1. The company has paid increasing dividends for at least 20 years – 154 entries this month!
  2. The stock has to have a Price to Earning that is lower than their industry average. The Price to Earnings Ratio has to below 20 regardless of industry average.
  3. The Operating Margin has to be in line with the particular stock’s industry average. I want companies that are profitable as compared to their peers.
  4. Price to Book – Should be below 4, but if it isn’t it must be in line with industry average (or lower).
  5. Dividend Yield – Moving target but always above 2.2%.  This changes whenever I update the list depending how many stocks I have left after the first 4 steps.
  6. Dividend Payout Ratio – It took me a long time to add this to my screen but basically I weed out any companies paying over 60% to shareholders.  Couple reasons.  The main one would be sustainability, but also, I do want growth in a company and if all dollars are going out it is likely to hurt the company in the long run.

I then purposefully look for dips in the particular equity insofar as I eyeball the 52 week numbers.  My thought process? is that I can lock up a few percentage gains if the thing just gets back to where it may have been at some point in the last year.  So, I am buying “cheap” stocks when they drop…sounds like I am inevitably going to one day fall into a value trap, right?

The next question for me is then does it matter if I plan on holding a company for years? a decade? until my son who is almost 4 is getting married?

An Example of What Could Have Been a Value Trap

Full disclosure: I handpicked this example after looking at a few of my positions.  I think it provides an example of what could have been someone bailing on a good business if they weren’t patient.

I bought WAG in 2012 and for that year it lagged the S&P

2012 WAG

WALGREENS 1/12 to 12/31/12

But I wasn’t looking for short term trade so it didn’t bother me.  I was holding a great company that was buying back shares, and increasing its dividend.

2012 to 2014 WAG Chart

2012 to 2014 WAG Chart

If someone had a year horizon they might have felt like they were in a trap, right? I mean it didn’t even beat the market in 2012.  However, as you can see from the above chart it destroyed it in 2013, and then compounding more into 2014.  I had sold some of my shares at $70 when it was grossly overvalued (although maybe I should have kept my head in the sand longer as it has come back after that initial drop to $60.

In conclusion, I don’t think I have been around long enough to actually see a value trap in hindsight – I couldn’t find any great examples when googling the concept either.

Does anyone have any experience with value traps?

By | 2015-01-05T16:28:01+00:00 November 13th, 2014|Investments|1 Comment

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Evan is the owner of My Journey to Millions which was started to track his journey from a broke debt ridden law school graduate to building a positive balance. Need more Evan? Follow him on Twitter, Contact him or get new posts directly to your email

One Comment

  1. Bashir August 5, 2017 at 2:05 am - Reply

    Does anyone have any experience with value traps?
    I may have some experience with one. It’s a Canadian junior mining company (actually a prospect generator to be exact), Transition Metals Corp. ticker symbol XTM.V and TNTMF on the OTC market. P/E ~ 2 & Price to Book value of about 0.81 (although price to book value is not a good metric when evaluating mining stocks, ROI is a better metric). The company has a market cap of $5 million, so it has been under the radar of most analysts, until recently Capital Cube algorithms evaluated the company and categorized it as potential value trap. Given that mining is highly cyclical (historically 20 year bear markets followed by 10 year bull markets) and we are ~5 years into a mining bear market, I may have another 15 years to go before base and precious metals, save gold which is doing well, increase in price which will be a major factor in driving the stock and the junior mining industry as whole. Yet little down side and potential upside is worth me risking a value trap. In fact a study I read on hundred baggers revealed many of the stocks they analyzed spent a significant amount of time under valued and with price stagnant (i.e. value trap) before the stocks began to move significantly towards the upside to achieve 100x gain. But who knows I can’t predict the future. If in 10 more years the stock price hasn’t increased than I will report back that indeed it was a value trap, although I hope to have better news than that.

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