Value Trap – A Menace for Novice Value Investors

What is a Value Trap?

Value Trap is a trap set for new investors with no or very little experience in Investing. It is basically an investment that appears to be less expensive with very low price ratios like Price to Earnings (P/E), Price to Book Value (P/B), and Price to Cash Flow (P/CF). Mostly, such stocks would be trading at grounded prices for a considerable time, like six months or more.

Value Trap stocks generally seem to be inexpensive compared to its peers in the industry and sector. Investors try to accumulate more and more with every fall in the price. It is like catching a falling knife. Only when the stock reaches almost zero levels, then the poor investors will find out that they have been trapped.

How is a trap laid?

One of the most common ways to trap investors into buying these poor quality exhausted stocks is by extensive campaigning and marketing by unscrupulous operators and stockbrokers. Their operatives call investors or send emails, messages with a tip to make them rich, luring investors into buying these stocks.

We can find their agents posting links and messages tricking the readers in financial forums into purchasing. Most of the penny stocks come under this category.

For a short period, we may find the price of the stock increasing at a swift rate, hitting upper circuits every day. News like the company acquiring more assets, replacement of the CEO, government’s favorable reforms towards the business, etc. will float around in the financial websites, media, and forums.

Even after the stocks start falling, we may witness the paid media and agents endorsing the company’s shares available at a cheap price as a great investment opportunity. Be cautious when you come across such statements like buy on dips despite the falling stock price.

Can we identify Value Traps?

Generally, it is challenging for a new investor to identify such traps since they are well covered. A lot of money is put into the business of supporting and spreading these poor stocks as worthy investment opportunities. 

Since basic fundamental ratios like P/E, P/B, P/CF, Dividend Yield are well covered. It’s a Herculean task for a novice investor to trace out these fraudulent stocks. But in-depth and thorough research and financial analysis help bring such traps into the light.

Primarily, such companies are bound to be with serious financial instabilities and business quality. Scan for the companies with obsolete business models and products, involvement in scams and diversion of investors’ funds, etc.

Any sudden decrease in the P/E, P/B, EV/EBITDA, ROE, etc. suggests that we have to be careful with such stocks. Bank stocks with a very low P/B ratio lower than 0.2 is a clear example. Share price witnessing a sudden drop by 90% or more like ₹100/- to ₹10/- within a year is the sign of a Value trap.

Some of the stocks that appear to be Value Traps trading at abysmally low prices are:

• Many large institutional investors are not interested in small-caps and other domestic businesses. So lack of institutional investment is one of the main reasons. High Ground Enterprise seems to be a good company with reasonable fundamentals, but it is trading at a P/B of 0.03. 
• Also, keep your distance from small-cap companies with ridiculous or similar names to famous companies. For instance, Birla Cotsyn is related to the acclaimed Birla Company. Therefore, you might feel it as a good investment, but it is a poor quality stock trading at ₹0.1/-.
• A share price deliberately increased by boosting from operators with very low volumes and without any appropriate reasons. For example, Ruchi Soya Industries share price shot up from ₹3.3/- to ₹730/- in six months.
• A fraudulent real estate company like HDIL, with very good P/E, P/B ratios. But the share is struggling at ₹1.55/-. It was trading at ₹1100/- in 2008.

Summary:

Stock markets are tricky places where you can make money or break yourself financially. It depends on the choices you make investing or trading in the market. Value investing is an exceptional strategy that can yield supreme results. 

Ben Graham and Warren Buffett are the best value investors ever in history. Buffett would have never become one of the richest in the world if it wasn’t for high-quality value investing.

There is a lot of difference between the value stocks and cheap stocks. Almost 90% or more of the penny stocks or cheap stocks are not suitable for investing at all. Maybe, some operators and traders would be able to make money from a sudden spike in the prices on a random day.

Be cautious with your hard-earned money. Follow some rules to make safe investments in the stock market. Here is my article explaining how to assess a stock.

Note:

I provide the information and my views on the website only to educate new investors, stock market enthusiasts, and the common public on equity or stock market investments. Please consult your financial adviser before making any investments in the stock market. In case of any queries, you can contact me via email ID: shivakumar.lachapeta@valueinvesting.online.