Learning to Spot (and Avoid) Value Traps

financial stock numbers

Value investors pride themselves on their ability to locate undervalued, under-appreciated stocks with a lot of untapped upside potential. It takes due diligence to be able to identify the key characteristics of a value stock – low P/E, low PEG and minimal debt. Many also have little to no analyst coverage, a dividend payment and a market cap of less than $2 billion. These stocks usually have one other defining characteristic – they usually haven’t been outperforming the broader indexes.

Unlike growth investors who focus on fast-growing companies with a high P/E and a chart that looks like a 45 degree upward climb, value investors prefer patience. By knowing a stocks true intrinsic value, they can wait out impatient investors, temporary trends and anything else that doesn’t interfere with the stocks future potential. But it’s not as easy as screening for just a few key ratios. Many would-be value stocks are actually traps that can quickly sink any portfolio.

Triggering the Trap

A real value stock has the potential for outsized gains. What separates a successful value investor from a poor one is knowing why the stock hasn’t yet reached its potential. After all, if an investor looks at a stock and comes to the conclusion it’s actually worth 15 percent more than its currently trading for, there has to be a reason.

There needs to be a catalyst for a value stock to go higher. Maybe its a cyclical stock that’s simply out of favor at the moment, or it has a promising new product that hasn’t been released yet. Whatever the reason, investors should be able to explain exactly what it is that will push the value stock up to its intrinsic value. If the only reason to buy a stock is because it’s priced cheaply, you could be looking at a value trap.

Some stocks that have a low P/E ratio might not be undervalued – there could be a perfectly good reason why it trades at such a low multiple. It could be that there isn’t much room for growth, or it might be in a dying industry. Investors need to be careful not to associate “low P/E” with “value.”

Another big trap happens with the dividend payment. A high dividend yield might be attractive for investors, but the payout ratio is what will reveal the companies ability to continue paying it. A payout ratio of more than 100 percent means that the company is paying out more in dividends than it earns in income – an unsustainable operation.

One of the hardest things for value investors to learn is patience. Sometimes a stocks intrinsic value isn’t realized for more than a year, making it a strategy for those who have a long term investment horizon. Warren Buffett says that if you aren’t willing to hold a stock for at least 10 years, then it’s not worth owning. True value plays happen over time, not in the course of just a few weeks.