Introduction
When the stock market turns bad, like it has been recently, investors find it extremely difficult to remain positive. As a result, people tend to be more cynical during bad times than they would normally be during better times. When this happens, it becomes all too easy to paint every stock in the stock market with the same negative brush. Since most stocks will, temporarily at least, experience falling prices during a bad market, the distinction between good stocks and bad stocks can become blurred.
As someone that believes in value investing, most of my work is focused on identifying strong and sound companies at attractive valuations. As I’ve written in the past, stocks do not become attractively valued when they are popular. But more importantly, popularity is not always justified by strong enough fundamentals, just as unpopularity can occur in spite of strong fundamentals. Nevertheless, one of the most common refrains I often run into when I write about what I believe is a strong company that has become attractively valued is someone will call it a “value trap.” Of course, this comment is typically applied when and because the company’s stock price has fallen.
Nevertheless, since I am typically writing about companies that I believe are fundamentally strong and healthy, I tend to react to the phrase “value trap” with cynicism of my own. If I see a good company that I believe the market is valuing too low, I see it as a “value opportunity.” However, my judgment is always based on my assessment of the company’s true fundamental value regardless of stock price. In contrast, and in my personal experience at least, the vast majority of the time that people call a company a value trap is predominantly based solely on a falling stock price.
In reality, there are low valued stocks that are in truth value traps, and there are low valued stocks that are in truth value opportunities. Making the distinction is not always straightforward and easy. However, when you get it right, the profit opportunities can be extraordinary. In other words, if you can successfully identify a true value opportunity, you can make outsized returns at reduced levels of risk. In contrast, if you mistakenly invest in a true value trap, you end up with outsized losses at significantly higher levels of risk.
The Definition of Value Trap
I believe the most important step towards avoiding value traps is to start by precisely defining what a value trap actually is. The reason I believe this is so important is because I have personally found that many people have a vague definition of what a value trap truly is. For example, here is one definition for value trap I found simply through Google:
“INVESTOPEDIA 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.”
Notice how the above definition focuses heavily on stock price movement. Important fundamentals such as earnings, cash flow and book value are vaguely alluded to in the opening sentence. However, from that point forward the focus turns to stock prices. Indistinct statements about low prices that never improve, trading and long periods of time, and stock prices may not move higher, do not satisfactorily define the term for me. The above definition talks too much about price and not enough about intrinsic value.
Admittedly, fundamental deterioration is perhaps alluded to, but in my opinion not focused on or clarified enough. For me to consider a company a value trap, I have to believe that there is a permanent long-term deterioration in the future fundamental strength and health of the company. To me, a company becomes a value trap when either it’s on the verge of going out of business, or poised for a long protracted period of collapsing or even disappearing earnings, cash flows, and inevitably dividend cuts or elimination.
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