What is a value trap?
If you’re a value investor, in other words you’re looking to invest in companies that are trading for less than their intrinsically worth, you need to watch out for value traps.
A value trap i
s a company that trades at a lower than expected share price, but fails to recover.
As a value investor, you’re looking to buy into a quality company where its low share price isn’t a reflection of its true value.
So if you come across a company that appears to be under-priced, you need to ask yourself two questions:
Why is the share under-priced?
How long is the share price going to take to recover?
Before you consider investing, you need to know the answer to these two questions, otherwise you could buy a value trap.
A recent value trap that investors fell for
For example, take what’s happened with the oil price, Charles Del Valle in Strategic Investor
In the middle of last year when the oil price started slipping, many investors bought shares of oil companies thinking that the drop would be short lived.
But instead, oil prices have continued their slide. And investors who bought into these shares at the early stage of the oil price decline have lost a lot of money now. A classic value trap.
And that doesn’t mean that oil companies are a good buy now even though they might look like they’re good value. Think about the impact of the oil price fall on their earnings and the steps they’re taking to cut costs.
This shows that you need to be patient to find out why a share price is down so much.
To answer how long a company’s share price is going to stay down for, you need to look at what could see prices jump higher again.
Avoid value traps and hone in on surprises
The secret here is to look for surprises.
For instance, a company’s share price is down, but it has healthy profit margins. The company would have to post better than expected profits to see its share price rise. Or if it manages to improve efficiencies or make a breakthrough in its field.
The key to success here is to avoid investing in companies that the market has high expectations of. Looking at companies with low expectations, but with a higher chance of beating these expectations can be a better bet.
The market loves surprises. And if you can invest in a company that surprises the market, you could reap the profits as the share price recovers.
But pick a value trap and you could be waiting a long time to make any money and losses are more likely.
So there you have it, how to ensure you don’t fall for a value trap.
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