Beware Of Value Traps

It is one thing to make a mistake in determining the stock, industry, or situation to invest in but it is an entirely different ball game to fall into a value trap

Over the course of our lives, we are faced with one decision making point or the other. We have to judge the best course of action to take based on the amount of information available to us.

For example, in deciding who you would like to settle down with, you can wager wrongly and fall into challenges. However, what’s worse is when you are trapped or deceived either based on how things seemed or because of the other party’s actions.

In the game of investment, the same holds. It is one thing to make a mistake in determining the stock, industry, or situation to invest in but it is an entirely different ball game to fall into a value trap.

Simply put, a value trap refers to any stock or situation that seems like it is a good one but is really bad. It is an illusion that seemingly offers investors a chance to make huge profits or increase the value of their investments higher than expected but ends up to be fake.

For example, the stock might appear to be cheap with room for growth but really might just have been trading at a low valuation for some issues being faced by the company. The usual metric towards determining whether a stock is good or not is by reviewing its financials.

While it has been said time and again that historical records do not guarantee the future of the company, they typically serve as guide to the overall position of the business. However, there are situations where the financial statements could be completely deceptive.

For example, the company might have had an internal challenge like breakdown of its equipment or loss of a key supplier that has permanently threatened its ability to get the same kind of results it was getting before. In this case, investors coming in who are oblivious to this new information would already fail before the news of the change is made.

It would then be too late because they would have lost their funds.

There are also situations where a company might have been going well and suddenly goes bankrupt. This is because the income statement might also have been hiding behind loopholes in accounting conventions. For example, provisions might mask a dent in the company’s financials.

Businesses might be funding long-term liabilities with current assets and other times, it could be that the business is going to have to pay significantly higher interest expense than it has disclosed thanks to changing conditions. This would ultimately drain its profits or revenue no matter how amazing it currently seems now.

Competition could also play a huge role in this. A new competitor might have emerged and the company might keep losing its market share to this new entrant.

In situations like these, even though the company might show a low stock price with an amazing trend, it would only a matter of time before the true nature of the business is revealed.

For the investor, there needs to be a consciousness towards finding value traps. In our next post, we would highlight some things to look out for so as to avoid falling into value traps.

Written by Lawretta Egba.