The 4 Value Traps That Fool Even Experienced Investors

Imagine this...

During your investment research, you find a stock that appears unusually cheap by nearly every valuation metric.

Your discounted cash flow model calculations show the stock is cheap even if growth dramatically slows down.

Believing there is a significant margin of safety, you buy some shares.

Yet over the next year, the stock underperforms significantly.

One of the many reasons the above scenario could happen is the all-too-common mistake of buying shares in a value trap.

A value trap is a stock that appears to be cheap but, in reality, is not due to deteriorating business conditions.

This is a mistake even experienced investors (including yours truly!) make.

Value traps are tricky because they happen at the intersection of the two most essential investing factors: valuation and quality.

In my experience, when I fall for a value trap, it’s usually when I’ve taken my focus off of a company’s quality because I’ve been seduced by what looks like an unusually attractive valuation.

As a simple example, imagine a stock is $20. The company made $4 in earnings per share (EPS). So, the price-to-earnings (P/E) ratio was only 5. This would undoubtedly appear cheap!

Yet the following year, because business is terrible, the EPS declines to $2. If the stock price stays the same, the stock will now have a P/E ratio of 10.

If, the next year, EPS decreases again, the same stock price would give it an even higher P/E ratio.

But, the market punishes poor performance, and the stock won’t sit still with declining EPS numbers.

In these situations, often the stock price will drop excessively.

Many times, the stock will drop so much that its valuation multiple will shrink below the 5 P/E ratio you thought was cheap.

All the while, you’ve lost a considerable amount of real money on what you thought was a sure thing.

Here are some common examples of value traps that we’ve seen ensnare investors:

A Business in Stage 6: Decline

This is probably the most common example of a value trap. What makes it so tricky is that it can come in a variety of flavors.

For instance, it can result from tech companies having their expertise commoditized away. Nokia and Blackberry cellphones were bestsellers before Apple released the first iPhone in 2007.

It can also be the result of companies playing in a dying industry. Even the makers of the best typewriters were doomed after desktop computers released word-processing software.

Some companies see explosive growth from the result of a fad. But when the fad dies, the company cannot recreate the magic with another product and quickly declines.

While a company can die in many ways, its accompanying decline in stock price will usually create a scenario that entangles investors in a trap.

Cyclical stocks at the peak of a cycle

When the price of crude oil reached an all-time high in 2007 at almost $150 per barrel, several energy companies looked cheap.

In 2008, Exxon Mobil showed $48 billion in profits-- a banner year. But, the downside was that It counld not match that peak profit number until 14 years later!

Similar cases could be shown of gold miners, agricultural businesses, chemical makers, and others that rise and fall with commodity prices.

Pharmaceutical companies with valuable patents set to expire

In 2013, Gilead Sciences achieved a medical breakthrough by developing a cure for Hepatitis C.

Gilead’s financials soared as patients rushed to buy the miracle drug, sending the stock price to new heights. Yet valuation multipoles made shares look unreasonably cheap.

However, as competitors entered the market and its customer base got cured, Gilead’s earnings fell. In 2022, the pharmaceutical’s EPS was down almost 40% from its peak earnings several years before.

Accounting issues

Financial media and analysts consistently questioned Enron’s numbers in the year leading up to its bankruptcy.

Another example is Wirecard. As early as 2015, articles were published questioning the company’s accounting practices. In 2020, the German payment processor declared bankruptcy shortly after announcing that billions of dollars were “missing” from its bank account.

Beware of companies that appear cheap and have questionable accounting practices.

These are some common value traps we’ve seen trip up savvy investors, but value traps can come in an almost infinite number of ways.

That’s why it’s important to look at the quality and sustainability of earnings that make a stock look cheap before investing.

Wishing you investing success!

Brian