INSIGHT

Value Trap





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Have you ever bought a stock you thought was cheap and it just got cheaper and cheaper? That is a value trap. It appears to be but in reality something has changed and the lower price is discounting or warning of deterioration or change ahead.

The Low Multiple Value Trap
Companies that have been trading at low multiples of earnings, cash flow or book value for an extended period of time because they have little promise and could deteriorate in the near future. Banks are recording low PB due to investors worrying on the quality of loan

Business Plan

Beware of a business plan that is not understandable or is unprofitable. If a company is unable to make profits or has a plan that is complicated and hard to explain – avoid it. Some companies has ventured into plantation, oil and gas, property, construction, where lack of focus is seen and synergy is not seen among the industries the management ventured into.

 

Obsolete Technology

If a product or service is outdated, it will most likely fail. Industry with bleak prospect, eg HDD, SSD, all HDD manufacturers may not deserve a high valuation.

 

Management

Quality management will give trustworthy guidance and demonstrate they have the knowledge to successfully guide the company.

If management is selling stock, holding pile of cash with no expansion plan, no debt obligation and no dividend payout. Management receive high directors remuneration. These would be signs of a possible value trap.

Eg: Companies where cash level > market cap, but stingy or non-existence dividend.

 

Accounting

Producing complicated or fraudulent company accounting reports often means there is additional hidden problems. Eg: Companies with huge cash holding but its interest income is proportionally low and management are asking for rights issue to raise cash.

 

Balance Sheet

High debt can cause problems with liquidity and solvency that can sink an otherwise good business plan. A strong balance sheet is the foundation of a quality company and provides a margin of safety. When a company faces adverse conditions a conservative capital structure gives them the financial flexibility to meet the challenges.

 

Eg: Companies that raise huge debt to venture into a new industries might face huge problem when the industry turn down. Some companies has low net profit due to large amount of gross profit is used to serve financing cost.

 

Strategic Advantages

A company that lacks strategic advantages to overcome tough competition or heavy regulations can lose their ability to compete. Before purchasing a cheap stock be sure the company has competitive advantages that will provide the cash flow and growth needed to raise the price of the stock.

 

Market leader, have economies of scale, pricing power, differentiation of product, cost benefits, or have powerful brands.

 

One off item

Some companies may one off gain or one-off impairment loss recorded in past income statement.

 

Cyclical Industry

Some business operates in cyclical industry where current earnings is not sustainable in the near future. Market has factor in the decreasing profit in the future, leading to a lower price willing to be paid by investors.

 

Industry overcapacity

Industry where multiple players are aggressively expanding their capacity in order to cut down their production cost and capture a larger market share. However, an overcapacity situation is often seen after their capacity expansion phase. A low barrier to enter this industry and industry producing homogenous items will worsen the situation. Eg: Photovoltaic cell, steel