Value traps are stocks that appear to be value stocks. But turn out to be poor investments and there are ways of spotting them out. This guide will help you avoid value traps. Consider these 8 situations that might signal that the stock you are analyzing is in fact a Value Trap.
Over leverage is always a bad sign, despite that you should understand how the debt repayment will go over time. Focus on the interest expense and refinancing ability of the company. Avoid companies whose cash flow is being sucked by interest payments, as they might not generate enough return. Also reject stocks which can’t raise funds, that shows that creditors view the company as very risky.
A decline in revenue is never a good sign, and could be a terrible signal about the company’s prospects. Review the different revenue streams and understand how which segment should behave in the future. Some sectors are in decline and it is wise to look elsewhere for opportunities, as companies are expected to perform poorly in the long run.
You should also consider staying away from stocks that are reducing their profit margin. It usually can signal that the competition is putting pressure as pricing becomes more important. Avoid companies where shrinking margins act as a way to maintain market share. This signals that the company will still struggle with completion in the long term and it could see it’s earnings decreasing.
When analyzing a company and the sector it operates in, you should be able to understand how the operations are being conducted in relation to the sector. Some sectors are cyclical. You will find stocks whose revenue has decreased due to the period within the cycle they are in. This is why it is important for you to deeply understand how a specific sector operates. So that when analyzing the company you can compare and put things in perspective.
Competitors Have A Bigger Moat
When a company’s competitive advantages start to erode, it is important to understand how the sector operates before reaching any conclusion. Some sectors and companies can be impacted in the short term but still have expected growth in the long term. It is important to differentiate between a company in a bad short term situation and the ones that have negative long term prospects. You should avoid companies who have been losing market share, and are dominated by competitors.
The decisions and the planning that goes into managing a company have a great correlation with the stock performance. Having great management that shares your views and creates shareholder value are great ways of ensuring the safety of your investment. Having a mediocre management team is like having a bad driver in a formula one car. Often things are not executed in the best way and to benefit investors. Destroying shareholder value, directly affecting the stock price. You should steer away from companies which are poorly run. An incapable management team will only destroy the value of your investment in the long run.
Often you will find companies who have a majority shareholder and their views might not be aligned with yours. In this situation it is better to avoid this kind of stock. As the majority shareholder might take actions to its benefit but that can negatively affect your investment. You should also understand how management is running things. And if their decision making is being influenced by the majority shareholder. It is important to understand the ownership structure of the company you are considering buying stock in. Figure out what their views on the company are going forward.
Unable To Grow Organically
If a company requires M&A to grow that could be a bad sign. The inability to grow organically in their segments is a clear sign that there won’t be much growth coming from existing operations. Some companies will resort to M&A to expand and grow, this could be a bad sign if integrating the acquisition doesn’t go as planned, or the merger doesn’t provide enough synergies or finally if it overpaid for the deal. In this situation you might want to stay away and see how the company will do before investing.
While looking for value stocks we often find situations where it is not easy to identify if one specific stock is undervalued or is doomed to fail. With this in mind you should ponder these topics when evaluating a specific stock in order to avoid value traps. With that in mind every stock is a specific situation that should be considered individually.
HERE are 8 ways to find undervalued stocks
Featured image source: Schroders