How to Spot a Value Trap and Finally Avoid It?

In the process of making the most from investing, one is always looking for value investing available at a lower price. So how does one go about identifying a value trap?

What are Value Traps?

A value trap when investing in a stock is – the share price appears to be cheaper, but in reality, it isn’t less expensive.

The stock seems to be trading at low valuation compared to its historical average or peers. However, in reality, it isn’t cheaper.

Depending on the calculation of the future free cash flow, price to earnings, or book value, the share price looks cheaper. The fact of the matter is, the share price is more about future value than that of the past. So a correct estimate of future value can help identify them as value vs. value traps.

Value Traps are Everywhere in Stock Market

Value traps are everywhere. Every bit of investing in the market is a value trap.

So let’s say Asian Paints is trading ~₹1700. But the earning for the company is around ~₹27

For a company that is earning ₹27, we are ready to pay ₹1700.

Now many value investors consider it too costly.

And tell them when they will consider investing in the same company and most will agree to invest at around ~₹1300

Is it a value or a value trap? The answer lies in the fact how the future of the company will shape in the next few years.

Similarly, HUL was around ₹1700 before Q2 results. The EPS of close to ₹28. The quarterly results show a volume growth of 7%. It is cheered by the market, and the stock rises more than 10% to ₹2000.

A company not growing at 10% but because it managed some growth and stock prices climb more than 10% from that stretch valuation is a value trap for many investors. For others, it is an investment opportunity because it is a secular growth story.

How to Spot a Value Trap?

Every stock that one invests in is a value trap. I believe value traps are everywhere.

In Oct 2016, I invested in my open portfolio in Pidilite around ~₹700 at a PE ratio of 44.

Some may consider it an excellent investment, but one can also look at it as a value trap — 44 times price to earnings for a company that at best may grow at 12 to 15%.

In hindsight, one can consider it a good investment, but the point is, will I invest in the same stock today at 44PE?

The answer is YES.

The reason is, I never consider investing in stock based on the price to earnings it is quoting at.

The way I look at it is the team and the management.

Does the team have the hunger to grow no matter what it takes? Will the Business pass my Checklist (Investment and Business) along with Fundamental Analysis?

So don’t spot a value trap. Consider every investment as a value trap. Make sure the investment in the company is such that they can manage the growth for the foreseeable future. If they can, the trap will release itself.

Make sure you are fine investing, assuming it can be a value trap and what will be the way out of the trap.

Most Important of all – How to Avoid a Value Trap?

Theoretically, you can’t, but technically stop loss can help you avoid a value trap.

In the Indian market, everything is either price to earnings or price to book.

My investment in Force Motors is a value trap.

I invested in the stock at 30PE when the peers were trading close to 40PE. It was a value trap in hindsight because the current PE of Force motors is 10PE.

Now considering the quarterly results and the way PE is shaping up, the stock may still be trading at close to 30PE one year forward earnings. The reason is, the stock lost 60 percent from my purchase price, but the PE also collapsed to the same extent.

Some may see it as a value trap. However, the way I see it, I couldn’t foresee the future EPS to be as low as it is now.

So the best way to avoid a value trap is to be able to estimate the future growth and earnings of the company correctly. Often you can get it wrong for a year or two, but in the long run, the estimates won’t be too wrong.

So investing in the right business and estimating their future cash generation capabilities can help avoid any value trap for sure.

Is it a Value Trap?

A company whose share price has been trading at 30 times the earnings for the past three years and is now available at 20 times?

Is it a value trap? Share your views in the comments below.