How To Spot Value Traps

A cheap stock could be a major value trap. Here are some tips to be on the lookout for in order to be able to spot value traps

Value traps are those stocks or companies that are not the amazing opportunities that they seem. The reason they are called traps is that they are generally enticing and many times only reveal their true nature when it is too late.

For example, a company might have been recording profits over the past decade and just lost permanently its ability to make money. This new piece of information might be oblivious to the investor and the company might still be receiving investments in an attempt to try to save it.

When it blows up, it would be too late. For the investor to avoid these type of companies, then he or she must be alert. This is particularly important for those investors who are constantly in search for better deals or amazing bargain opportunities – if it is too good to be true, it probably is.

A cheap stock could be a major value trap. Here are some tips to be on the lookout for in order to be able to spot value traps:

Unclear Management Vision

The company might have been great in the past, but might simply be holding on to that glory and not doing so much to forge ahead. You would notice them attempting different management strategies that never solidify.

Their strategic vision might be hazy and they might have zero catalysts to propel it. It has no new products it wants to try and is simply just moving with the times. Without a clear vision, the company’s stock would soon stop ticking.

High Leverage

Debt isn’t a bad source of funding for any company. In fact, the pecking order theory ranks it higher than equity. With debt, you don’t lose a portion of your ownership.

However, when a company is overly reliant on debt to succeed, then it means it isn’t making enough money to handle its operations. High leverage is one of the strongest indicators for value traps. Beware.

Loss in Market Share

The business might really just keep losing market share and this could come in different ways. It could be as a result of new completion and it could also just mean their product or service is losing relevance.

No matter how much the biggest typewriter company was making, it really had no chance with the advent of the portable computer.

Operating higher than its means

Nothing ever works out when you spend more money than you’re making. The company might have its revenue in the same position or might even be having working capital issues.

If it doesn’t try to cut down on its expenses, then it is only a matter of time before everything comes crashing down. For example, if the company is still having a high management compensation scheme despite its financial challenges, then it means that they are not maximizing their funds to change the situation of the company for the better.

Setting Unachievable goals

The management might in fact still be setting goals and creating strategies, but it is important to consider the viability of these strategies. Are they achievable considering the state of the economy and other relevant issues?

Does their timeline for achieving this seem reasonable enough? Unrealistic goals are only pretty on paper. However, they do not hold water at the end of the day.

Low price because it isn’t growing

Sometimes, the answer isn’t so far-fetched. If the company stock has a low price, it probably means that it just isn’t growing. That could simply be its peak. If their multiples have been low for an extended period of time, it probably means that it really doesn’t have a good future ahead of it.

Bear these in mind and you will circumvent many traps before it is too late.

Written by Lawretta Egba.