How do you know that cheap stock you are interested in isn’t a value trap?

Buying cheap stocks isn’t the same as value investing. That’s a very important point you always need to remember.

There are loads of cheap stocks on the stock market.

Some of them are good. Some of them are utter rubbish.

So how do you know the difference?

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What is a value trap?

A value trap is an investment that trades at really cheap levels and presents what looks like an attractive investment opportunity.

This would typically include a low PE ratio and a low price to book ratio.

But then the company’s share price just never budges and sticks to these low levels.

Eventually information might emerge explaining why the stock remained this low, showing there is something wrong with the business or the investment case.

What makes this difficult is that a value trap and a value stock share the characteristics of a low PE and low price to book ratio.

What to look out for to avoid a value trap?

There are a number of things that can explain why a company is really cheap – so first ask yourself these questions:

Characteristic #1 – Is the company cyclical

Poultry companies for instance are usually cyclical. In times of good rainfall conditions there are big harvests of soybeans and maize. And that means feed costs are lower. This would help a poultry company make big profits.

But good harvests are always followed by bad harvests. And that means rising commodity costs, and rising feed costs. This will damage the profits of a poultry business.

So, because earnings are backwards looking the PE ratio of a poultry company could be really low and its share price down – because the market is anticipating a drop in profits due to rising feed costs.

In this case the poultry company ‘looks’ cheap, but it won’t remain cheap. It is a classic value trap.

So always ensure the reason for the company looking cheap isn’t because it is merely heading into a downward cycle, and the market is already anticipating this.

Characteristic #2 – Profits aren’t backed by cashflow

A low PE ratio means the company makes a lot of profit in comparison to its share price.

That’s all well and good. As long as the profits are of the right kind. That means we want to see profits backed by cashflow.

Remember, a company can declare revenue or sales on credit as well as cash. But at the end of the day, we want to see cash in the bank rather than a big pool of debtors.

More often than not, a company with bad cash conversion is a value trap, whereas one that banks as much cash as the profits it declares is a value opportunity!

Characteristic #3 – Sometimes a value trap can be a great business as well

Not all value traps are bad companies…

A value trap could in specific conditions also be a company that’s otherwise a perfect investment.

So how is this possible?

Well, it’s got to do with the company’s ‘free float’ – the amount of shares in the company that is available to trade by the public.

Let’s say a company is owned 95% by management or other core shareholders. They don’t sell their shares at all.

That means only 5% of the business is available to buy by the public.

Now, while insiders owning shares in a company is good, it can also cause really bad liquidity. And this would mean that there would simply be very little interest in the stock, as it is not tradeable.

So even though its financials might be good, without investor interest the share price won’t move and the stock could become a value trap!

Characteristic #4 – It is simply too boring

A boring business with good cashflows and big profits – that’s the typical Warren Buffett kind of stock.

But there’s a point where a business could become TOO boring.

Companies and stocks need catalysts in order to advance. If a company doesn’t have new products on the horizon nor expects to show earnings growth or momentum of some kind, consider avoiding it.

A company’s history should never be overlooked, and it should be compared to what the company’s current financial statements look like. If the company cannot improve upon its position operationally, it may have trouble competing with companies that can. Ultimately, the company will probably also have trouble garnering interest from the investment community.

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