Value Traps

Investors searching for value opportunities sometimes encounter a dreaded creature known as a 'Value Trap'. These so-called 'cheap' stocks appear to be valued very cheaply, but end up moving sideways for years on end, and never deliver superior returns. In this post, I will try to explore a few of the characteristics of 'Value Traps'.

Low P/E or P/B Trap
Companies trading at low multiples are probably trading at that valuation for a reason, which could range from low growth prospects, declining industry, hyper competition, high debt, etc. Some of these features are insurmountable, and hence the company/ industry might destined to remain at low multiples. Investing in low P/E companies is thus advisable only in companies with sound fundamentals, and is likely to lead to disappointments if followed as a mechanical strategy.

Lack of Catalysts
This is a follow-up to the previous point. Companies trading at cheap valuations usually do so for a reason. The way to get out of this is for the company to have some catalyst which leads to a re-rating of the stock. Catalysts range from launch of new products, a breakthrough R&D success, consolidation, deleveraging, etc.

Without a catalyst, a company is likely to remain cheap. It is when the catalyst is realised, that the company attains momentum in earnings, and catches the attention of the rest of the street. Anticipating potential catalysts and waiting for the company to harness them is what separates the value investor from the rest of the investing/ speculating community, and often leads to the best returns.

Low Proportion of Free-Float
Often, the best trigger for a re-rating of a company is when buzz starts to build up regarding a change of management through a takeover, merger or a management buy-out. Typically, in such cases, the market is frustrated with the management's inability to push through changes which unlock value. When a takeover opportunity appears, the market laps up the company's shares in the hope that new management will be able to change the fortunes of the company.

However, the above usually works when a significant proportion of the company's shares trade in free float. Incumbent managements and owners are normally reluctant to relinquish control, and it often comes down to an acquisition to unlock value. However, companies with high insider ownership can try to scuttle such takeovers by blocking it using their voting rights.

This prevents any re-rating from taking place.