Saturday, July 4, 2015

10 Worrying Signs that Your Stock May be a Value Trap


Value Investing is all about identifying stocks with unidentified or underappreciated potential and waiting for that value to be realised over time. However, it's always worth remembering that some stocks are cheap for a reason. Of course, we all hope that the market will come to recognise what a bargain our latest investment was. But, every now and then, a price fall may lure you into every value-investor's nightmare - a false bargain, better known as a value trap.

What is a Value Trap? 

A value trap is a company that appears cheap because of a large price fall, but which is actually still expensive relative to intrinsic value. In effect, it is masquerading as a value stock. It looks like a bargain price because it has come down so much but, despite the allure of a low price, a value trap's price is low for a good reason - unlike a true value stock, these companies are experiencing a fundamental change in their business prospects and could basically dying companies. As Warren Buffet said, “price is what you pay, value what you get".
Timothy Fidler of Ariel Focus suggests that there are two main types of value traps: 
1  Earnings-driven value trap - This is where the mirage of a low price/earnings valuation vanishes as EPS evaporates over time - every time you think it looks "cheap" again, earnings fall further. This process is usually persistent and can last for years. More often than not, the misguided investment thesis is some variation of "They used to earn X, so if they could just get back to something near X, the stock would work well".
2  Asset-based value trap - Also known as "cigar-butts", these types of stocks look exceptionally cheap in terms of asset valuation (e.g. the price/book ratio relative to current profitability). In some cases, the trap is simply that the reversion to the mean of unsustainably high profitability. However, Fidler suggest that the real danger comes from companies with opaque or ill-defined risks where the flawed investment thesis is "I know the risk is there, but I think it is already in the price or over-discounted".

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....

Top 10 Signs that Your Stock May be a Value Trap

In no particular order, these tell-tale signs are:

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 realise 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. This is the trap that Warren Buffett faced at Berkshire Hathaway, which was a failing textiles business that he was unable to turn around before he switched the focus completely into insurance.

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 (e.g. the impact of the Internet on both newspapers and retailers). Chanos argues that this has killed value investors more than anything in the past 10-20 years. 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. A example given was Blockbuster which apparently saw free-cash-flow go from $2bn to $500m in just 18 months! Having said all that, the cycle of creative destruction can be unpredictable - the US steel industry was given up for dead in the 1980s but was reinvigorated by the invention of lightweight mini-mills. 

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. An example here might be K-Mart which looked extremely cheap in the late 1990s vs.  say Walmart but the lack of a competitive business model meant that the company's earnings continued to plummet. Because of leverage (see next point!), Kmart filed for bankruptcy in 2002. Alternatively, maybe it was just a dumb idea in the first place, or a good idea badly-executed. While Tesco have shown that online grocery deliveries can work, WebVan burnt through $375 million in the dotcom era through investors overlooking extremely thin margins, unreliable delivery times, and a lack of customer demand.

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. Conservative financing is one of the key criterion discussed as part of the Buffetology screen. 

5. Is the accounting flawed or overly aggressive?

It's best to stay away from companies where aggressive or dubious accounting is employed. Chanos argues that you should be “triply careful” whenever management uses some metric that they define, rather than conventional metrics (Cable TV, Eastman Kodak, Blockbuster, and Tyco have been examples of this in the past). If a company is only cheap on management's metrics, such as EBITDA while ignoring restructuring charges, this means very little. 
Likewise, it's probably best to avoid with a wide berth stocks that have dropped in price due to to corporate fraud. Some investors bought Parmalat’s bonds in the summer of 2003 on the basis that they were cheap for a company with a strong cash position and balance sheet only to find that the Italian dairy group collapsed later that year with €14bn ($18.5bn) of debts. Published financial statements always have to be taken with a grain of salt and, wherever fraud is involved, the figures used to determine value are probably meaningless. Montier's C-Score and the Beneish M-Score may both help to flag issues here. 

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 ove 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. An example of this is arguably Hot Tuna - as Growth Company Investor has noted:
"the surfwear fashion concept has for some years become increasingly out of fashion since the late nineties... with Hot Tuna reporting losses every year since 2006". 

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. In general, while there are notable exceptions (e.g. Berkshire Hathaway), investors should probably be wary of companies with a second class of stock with super-voting rights. The risk here is that that the company will focus on keeping insiders happy at the expense of common shareholders. A related flag is a very limited float or tightly held company - while insider ownership can mean that incentives are aligned, it may also act as a deterrent for institutional shareholder participation (since they will find it difficult to trade in large quantities of stock). 

10. Has the business grown by acquisition?

Chanos argues that growth by acquisition is a major sign of a value trap. In particular, rollups of low growth, low P/E businesses with expensive high P/E stock should be seen as a red flag. Be careful when you see big write-downs because, while management is claiming to be conservative, they are likely to be banking some earnings. Chanos gave the example of Tyco - in its last year of business, it apparently bought $20 billion worth of businesses, and put $21 billion of goodwill on its books!

And you still need a catalyst...

Even if the investment doesn't suffer from any of these risks, the investment may still end up being a dreary and difficult one, if there's no near-term catalyst for the crystallisation of value. Via Expecting Value, we came across a useful catalyst definition by value blogger, Wexboy as:
"any kind of transaction/fact/event/etc., actual or potential, that offers the opportunity for a full/partial realization of value in a stock, within a (reasonably) accelerated timescale". 
Many seasoned investors and sell-side analysts wait until a catalyst gets ready to hit the market and buy or recommend the stock then. In the absence of any obvious catalyst, time will probably do the trick eventually but, in the long run, we are all dead. And, as Wexboy notes, an extended wait for value to be crystallised can have a dramatic effect on your returns: 
"You’ve found a neglected jewel, and based on your value investing acumen (and a decent Margin of Safety) you confidently expect that will ultimately capture an upside of, say, 75%. But when will that happen? In 3 yrs, 5 yrs, 7 yrs..?! Those periods equate to IRRsof 20.5%, 11.8% and 8.3% pa respectively. Now assume a catalyst exists that’s successful in prompting a realization of that full 75% upside within 1 year. That is, of course, a 75% IRR! "
Some examples of possible catalysts include: i) fresh management with new direction, ii) a change in strategy of existing management (e.g. new product strategy, business reorganisation or cost reductions), iii) a disposal or purchase of a meaningful asset, iv) a recapitalisation of the business, v) a takeover bid, or vi) activist shareholders who may put pressure on management to act. 


The process by which value is realised or crystallised is one of the great riddles of the stock-market. As Benjamin Graham noted in his testimony to the Senate Banking Committee in 1955, while it may sometimes take the market an inconveniently long time to adjust to intrinsic value, the beauty of the market is that it usually does get there eventually.
The Chairman: When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about – by advertising or what happens?
 Mr. Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it one way or another.
However, while patience is a virtue, patience should not be confused with naive optimism. As Warren Buffett has said, "in a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen". One way to ensure that you're not left waiting forever for value to be crystallised is to review the above criteria and avoid value traps at all cost. And focus on identifying catalysts to unlock value quickly, wherever possible. 
is all about identifying stocks with unidentified or underappreciated potential and waiting for that value to be realised over time. However, it's always worth remembering that some stocks are cheap for a reason. Of course, we all hope that the market will come to recognise what a bargain our latest investment was. But, every now and then, a price fall may lure you into every value-investor's nightmare - a false bargain, better known as a value trap.  - See more at:


  1. nice article..liked the conclusion very much...

  2. again wonderful article ..
    reading become habit on Saturday

    Dharmesh Jhaveri

  3. Hi VP sir , Would like to check your view on Chembond at current CMP?

    1. Positive on business . Stock already suggested @ Rs.190.One can still hold @ CMP Rs.375

  4. sir ,

    your view on CCL product ? can it be bought for next 2 yr view ?

  5. Sir what is your view on Good Luck Steel Tubes..

  6. Very nice article sir. Thanks for sharing

  7. sir ur views on saint gobain, wonderala , adlabs

    1. Tracking only Wonderla and positive on its long term prospects

  8. sir ur thoughts on

    tatasponge iron
    suven life sciences

    1. Not tracking any of these companies

    2. Dear Sudheer , Has VP ever suggested any Anil Ambani's company ?

  9. Vp.sir, wat u think of avanti feeds outcome of board meeting from a 4-5 years perspective and its effect on share price?

    1. Avanti Feeds is one stock suggested @ Rs.68 .

      Nothing to add at current price Rs.1773

  10. Sirji.
    Trying my luck for 3rd time. Plz share ur esteem views on prima plastic.

    1. No need to try luck 3 times , just check once whether already replied . I am not tracking this stock

  11. Your current view on IDFC , now that it has got banking license. Should we buy the stock now (Rs 151) or wait after demerger and buy IDFC Bank Ltd.

  12. Sir, good insight to value trap..
    Your view on Cairn being proposed to merge with Vendanta? Is this not unfair for shareholders of Cairn based on cash in balance sheet and timing whne oil prices in down cycle. Cairn once bluechip was diminished in value by Vedanta gp bought over, not sure what value they brought in the company! You had suggested Cairn as part of stock portfolio long time back though.

    1. Not tracking after the take over of Cairn by Vedanta

  13. Hey Value-picks, i have

    1. 1000 shares of Jaiprakash associates at avg price of 75, currently its trading at 11 and
    2. 1000 shares of punj loyd at avg price of 49, currently its trading at 25.

    whats your view on both these stocks? and also suggest me whether to average them further or wait for some more time?


    1. At least ten times I replied that I am not tracking any company from JP group

      Not tracking Punj lloyd too

  14. Sir what are your views on Garware Wall Ropes.

  15. Sir, what is your view for Sakthi finance script code 511066 NBFC company

  16. Dear Sir
    What is your view on JBF Industries?
    Rajesh Rajput

  17. respected vp,your valuable views on arrow coated promoters decision to change the name of the company.thanks for this wonderful find,this stock has changed life of many investors including me-avinash

  18. Dear vp sir, wats ur view on sequent it overpriced or is it is still a hold considering various acquisitions and capex plans company has recently announced.

  19. Dear VP,

    What's your view on Mega Soft ?

  20. Helo VP sir.
    Hindustan tin works is almost trading at 52 week there any change in ur views for this co. Plz share

    1. No change in opinion expressed in below link

  21. Dear sir,
    your old recommonded stock Premier explosived today zoomed to 403 levels. thanks .

    1. Yes , it suggested at Rs.73

  22. Hi all,
    Had invested in V2 retail, based on VP's article and some faith in the promoter .Its turning around slowly, and the share price has gone up ! But not sure if they are ready to adopt e-com /m-com as future direction. I went to the site and they have only 3 shirts for men ! 0 Salwar suits for women. Many other categories in women / home have no products at all. So while they may be readying the site for 2 years down the line, for the near term, the website and e-business are not ready, Just sharing the info. I saw...

  23. Kopran has announced sale of Consumer Care division.

    1. Out of Rs.318 Cr sales Kopran reported in last year , contribution of Consumer care division is less than Rs.3 Cr . This clearly indicating company's plan not materialized as expected, and at the same time pharma division is doing well . Hence, it is better to exit from consumer division before burning more money for that and concentrate in pharma division where company is well experienced

  24. Sir

    I want to invest in some of these stocks from your old reco.
    1) Excel Industries @270
    2) Patel Airtemp @140
    3) Camphor and allied @350
    4) aksh optico fibre@18

    Kindly let me know which can be bought at current levels pls

    1. 'Value Investing ' never means buying a stock at any rate

  25. Sir wats ur view on welspun corp,nandan denim,nocil and gati

  26. Why are you not shared Graph or Image?

    1. My stocks suggestions not based on technicals

  27. Siddharth BhaskarJuly 17, 2015 at 9:44 AM

    Hi Sir,
    Please share your view on the following:
    1. Mahindra holidays
    2. Cox & kings
    3. Jet airways
    4. DCB bank
    5. Hindalco

    Also are there any pharma stocks that are attractive at this point that we should lookout for?

    Awaiting your response.

  28. Sir please approve my friend request on facebook so that I can learn from your valuable tips and suggestions !



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