Beware The Value Trap

With the recent purchase of HBC by Jerry Zucker many investors were wondering aloud if Jerry had just bought himself a ‘value trap’. I began to think that any value investor could purchase themselves a value trap if they had not done some home work.

A quick definition of a value trap is when a stock has experienced a large price depreciation and is mistaken to be a value stock and the investor purchases the stock hoping for a price appreciation only to find that the price keeps dropping. Unfortunately, many investors mistake a low stock price for an undervalued stock and get sucked into buying it and find themselves with a value trap in their portfolio. Not every stock that has seen its price battered is a good value.

Most investors that purchase value traps solely look at the price of the stock and assume that it is a good value. Blindly picking stocks in this manner could take a few years off your life because of the stress of seeing your portfolio drop like a bad habit. Many value traps are once good companies that are experiencing a fundamental change in their business prospects and could be classified as dying companies. HBC is a good example of a potential value trap because of the fundamental shift happening in the retail sector. e.g. Wal-Mart
Most value traps are due to poor or lazy management. An entrenched management team that doesn’t care what happens to the company or is set on pursuing growth initiatives that don’t make any sense can have a disastrous effect on a company. If you find a cheap stock and can’t figure out why it is so cheap, move on, it’s probably bad management. You could miss out on a company that might turnaround but I’d be willing to miss that small percentage to avoid a value trap. If management isn’t working towards making the company a well run profitable venture you could be waiting years for your investment to turn a profit.

The best way to avoid a value trap is to ask some questions:

  1. Is this company highly leveraged? Most value traps are highly leveraged companies that never really generated enough free cash flow to support their past high valuations. (Also, a company with high debt may not stay alive to turn around)
  2. What are the business prospects for this company? Answering each of the five Porter questions to gain an understanding of its competitive environment is helpful.
    • Are there barriers to entry for new competitors?
    • Are there issues with powerful suppliers that can have an impact on pricing or other aspects of business?
    • Is there dependence on powerful customers?
    • Are there substitutes for the product or service offered?
    • Is there a tendency for the industry to compete ruinously on price to squeeze margins?
  3. Does management care? As I said previously, poor management is the main culprit for a value trap.
  4. What is the history of earnings estimates? Frequent negative earnings surprises are a huge big red flag. This would indicate to me that management doesn’t understand or are not willing to fix problems.
  5. What do the fundamentals tell me? The investor needs to understand the earnings and revenue history of the company. Also, dividend discount or discounted cash flow models can help determine the
    stocks intrinsic value.

The Holy Grail for the value investor is to find that quality company trading well below a conservatively calculated intrinsic value of the probable future earnings ready to burst out of its slump and earn the investor riches. However, the value trap is a common problem in value investing for those who only look at the price and don’t look at the fundamentals or take into consideration management and business prospects.

We at Investorsfriend do a comprehensive fundamental analysis of the ratios and earnings history, judge the motivation of management, and look at the competitive environment for a company with a discerning eye. This will help you, the investor, to avoid those value traps that can trap your money for years waiting for a turnaround.

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Steve Wesch, Associate Editor
InvestorsFriend Inc.
February 11, 2006