5 Methods To Avoid Value Traps ....

Courtesy : Investopedia

In essence, value investing is the practice of identifying financially sound companies with solid future growth prospects that are available at attractively low valuations, with the company's stock trading below its intrinsic value. Some value investors have been drawn into value traps, in which they buy into stocks that may be low priced but that are not genuinely undervalued and whose stock prices may fall substantially further due to company or industry specific conditions that are long-term problems rather than just temporary setbacks.

There are relatively low-priced stocks that are genuine value investing opportunities, and then there are stocks that are low-priced value traps. Learn to look beyond just a low price and maintain a focus on strong fundamentals for a company and the industry in which it is engaged. Here are five warning signs that a stock may be a value trap rather than a real value investing opportunity.

1) A Bad Business Model

No matter how promising a company's statements on its website may seem or how attractively low its stock price may appear, be wary of any company that doesn't have a business model that is both easily understandable and clearly aimed at being profitable. If you can't easily and clearly see how the company's business model should lead to success and profitable revenues, it's probably best to avoid the stock no matter how temptingly low the price may look. Be especially wary of companies that rely on outdated technology. In today's rapidly changing economic world, a company offering a product or service that is outdated, or soon to be outdated, is in serious trouble. This kind of trouble usually results in a stock price that just continues to drop. Technological obsolescence has led to the downfall of many a business in the past couple of decades.

2) Price Too Cheap Compared to Earnings

The price-to-earnings ratio (P/E) is a good financial metric to consider when determining whether a stock is really a bargain or a value trap. If a company's stock price has dropped to the point where it is unreasonably cheap in comparison to earnings, this is often a strong indication that the company is fundamentally unsound. Since the market generally prices stocks in relation to future expected cash flows, consider the forward P/E ratio as well as the trailing P/E.

3) Too Much Debt

Many promising businesses have been undone and sent into bankruptcy by allowing themselves to become overly leveraged. The adage is true that it's much easier to pile up debt than it is to get rid of it. If a company's revenues and stock price have declined, the interest on its outstanding debt becomes a larger percentage of revenues and income. When this happens, the debt usually becomes increasingly difficult to manage. A company carrying a dangerously high debt load has very little room for error or even for minor setbacks in the marketplace. It's probably best to shy away from stocks that have substantially higher debt to equity (D/E) ratios than the industry average.

4) Lack of Competitive Advantage in the Marketplace

Virtually every market sector is increasingly competitive. If you can't look at a company and clearly see that it has a competitive advantage, then it very well may not have one. Consider potential sources of market advantage, such as unique products or proprietary technology, brand identity, less expensive suppliers or production costs, cash reserves or location. Unless a company has at least one competitive advantage that should allow it to succeed on a higher level than its competitors, it is not likely to thrive and grow, and that applies to the value of its stock as well.

5) Lack of Insider Buying

One of the clearest warning signs to stay away from a stock is a lack of insider buying or, even worse, signs of substantial insider selling. Include hedge fund and mutual fund managers in the group of insiders, and be careful if the percentage of funds holding a stock is dropping substantially. If company insiders aren't anxious to scoop up shares of the stock at what looks like a bargain price, then the stock probably isn't such a bargain after all.