BASICS FOR BEGINNERS ....

Courtesy : Investopedia, Stockopedia

VALUE TRAP 

DEFINITION of 'Value Trap'

  

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. 

                                                                        Companies, and even sectors, can be doomed, because of situations such as the inability to survive competition, the inability to generate substantial and consistent profits, the lack of new products or earnings growth, or ineffective management. Often, a value trap appears to be such a good deal that investors become confused when the stock fails to perform. As with any investment decision, thorough research and evaluation is recommended before investing in any company that appears cheap when reviewing its relevant performance metrics.

How to avoid Value Traps...

Of course, it's easy to say with hindsight that a failed investment was a value-trap but are there any ways to flag this in advance? Fundamentally, the key to avoiding value traps is doing your homework and exercising  caution when approaching enticing investment prospects. It's crucial to be as precise as possible about intrinsic value through fundamental bottom-up company analysis. The other issue is that it's important to have an adequate margin of safety since this is the value investor's buffer against errors in the intrinsic value calculation. However, beyond that, there are some common fact-patterns that it's worth watching out for....

Few  Signs that Your Stock May be a Value Trap

1. Is the sector in long-term secular decline?

A company may simply be serving a market that no longer exists in the way it used to. No matter how good the company, it will need a fair wind behind it eventually and and if the sector itself is dying, it's likely to be a huge battle to realize value. From a demand perspective, it's important to distinguish between cyclical and secular declines. In the former case, short-term demand will rebound with an improved economy. In the latter case, demand is in long-term decline (e.g. due to societal and demographic changes), which means that the remaining players are left to fight for a share of an ever-decreasing pie.

2. Is the risk of technological obsolescence high?

Technological progress can radically reshape an industry and its product lines - this can have a major impact on the life cycle and profitability of a firm .One might assume that a stock is cheap enough to compensate for decreasing cash flow but, sometimes, cash flows hits a tipping point and drops off faster than you expect. 

3. Is the company’s business model fundamentally flawed?

Sometimes, a company may simply be serving a market that no longer exists, or at a price-point that is no longer relevant, given competition and/or new substitutes for the product. 

 4. Is there excessive debt on the books? 

More often than not, financial leverage magnifies the pain of a value trap. Limited or no financial leverage gives firms access to the the most precious commodity of all - time! A company with no debt is unlikely to go under, barring a major catastrophe (e.g. a massive legal settlement against it). On the other hand, excessive leverage can destroy even a great company. For a good margin of safety, the debt to equity ratio should be as low as possible  and interest cover should be comfortable

5. Is the accounting flawed or overly aggressive ?

It's best to stay away from companies where aggressive or dubious accounting is employed. You should be “triply careful” whenever management uses some metric that they define, rather than conventional metrics .

6. Are there excessive earnings-estimate revisions? 

Analysts are quite lenient and usually revise their estimates downward before earning releases to allow companies to beat their estimates. Occasional missed earning estimates can provide an opportunity to buy on the dip, but a pattern of missing earning estimates may mean that management are struggling to forecast properly, with a knock-on effect for the analysts, and/or that management doesn’t understand or are not willing to fix problems.

7. Is competition escalating?

Be careful of companies facing increasingly stiff competition. Is there a tendency for the industry to compete on price to squeeze margins? If there are limited barriers to entry and a company is unable to differentiate itself, then it's possible that the market structure has simply moved against it - it may never recover the glory years of the past. One way to test this is to compare the historic profit margin trend over the last 10 years. If the profit margins are decreasing, this may suggests the company is unable to pass increasing costs onto its customers due to increased price competition

8. Is the product a consumer fad?

Another sign of a possible value trap is a product that is subject to consumer fashion or whims. Evolving consumer tastes and demand may mean that the market for the product is just a short-term phenomenon

9.   Are there any worrying corporate governance noises?

It's worth checking for any history or noise that suggests minority shareholders might be getting a raw deal .