A cheap share? 10 warning signs of a "value trap"

If you invest in individual shares, picking the "right" shares is no easy task. Different strategies are possible. Contrarian investing by buying exactly those shares that "everyone" is dumping. Investing in trends by trying to coast on the upward and downward (technical) trends of a share. Or investing in value by trying to buy undervalued shares at rock bottom prices.

Value investing is a particularly popular strategy among stock pickers. Simply put, it’s about selecting shares that are trading below their book value or intrinsic value (buying a share just because the price has fallen is never a good idea). You then have to wait for everyone else to realise that the share is undervalued. This can be very successful. But can also be less good, if it turns out that it is not an undervalued share, but a "value trap". 

Here are some signals that can help you recognise a value trap:

1. Performing less well compared to peers in the sector

It is best to never analyse a share in isolation. Always compare its performance to that of its peers. If the company is at the top of its cycle, but is still showing less growth than its peers, something may be going wrong.

2. Strong dependency on a limited number of products or economic climates

Here, the value trap is that the company’s profits may have been exceptionally high for some time now, and you mistakenly price in the expectation that current earnings level will remain sustainable in the long term. When economic conditions change or a major product falls out of favour, both the company’s earnings and its valuation will fall, resulting in a significant drop in the share price. For example, a question you can ask yourself in this context is: will the company still make as much profit once the coronavirus crisis is over?

3. Management salaries remain high

All companies pass through ups and downs. However, a drop in share prices or medium-term earnings should also normally mean that management salary costs fall or that there is some "intervention". This indicates a responsible and alert management team. If the company’s profits have been sloping downwards a long time, but nothing much is changing about the company’s management, this can be an alarm signal.

4. Continuously declining market share

A company’s market share is an indicator of how it is performing in relation to its competitors. If the company is constantly losing market share, there is a good chance that it is a value trap. Typically, rising market share is accompanied by rising share prices and vice versa.

5. Inefficient capital allocation

A company maybe has a robust free cash flow, but is unable to allocate capital efficiently to stimulate the business? This can also be a value trap. If you only look at the free cash flow and compare it with other companies in the sector, you can be misled. So make sure you also look at the efficiency of the capital allocation to assess whether the company is making the best use of shareholder capital. This can be done using the "return on equity" ratio. The "return on assets" ratio can also tell you something about how the company manages its total assets.

6. Mountainous debts

If a company has debts that represent a multiple of its annual turnover, you run the risk of staring at a huge value trap. The easiest way to determine this is to calculate the "debt to equity" ratio.

7. Wanting to do it, but not being able to, allowed to or daring to

A company that is going downhill will normally want to make a fresh start. However, you may be falling into a value trap if management "wants" to do so, but "can't" do so. This might be due, for example, to rock-solid trade unions that are blocking changes, or government intervention. Also take a close look at the management. If they all look the same and have the same opinions, the likelihood of change is much lower. The absence of activist investors may also be a sign that there is little hope of any change.

8. The halo effect

Tim Cook, Jeff Bezos or Elon Musk taking on the top job at General Electric? Having a successful or respected management team can lead to investors being blinded to the challenges a company faces. Rather than focusing on the fundamentals of a business, investors can be lulled into a false sense of security by believing that management knows what it is doing and will always take care of things. Or that, if well-known investors have bought shares in the company, the risks must actually be less than they appear.

9. Only looking in the rear-view mirror and never through the windscreen

When value investors look at the profit that a company should be able to make, they tend to look at the past rather than the future. Although this can indeed be a guide to future profits, it can also lull them into a false sense of security. It is therefore important not to be complacent, and to pay attention to the potential Kodaks of tomorrow.

10. Woolly vision

A woolly vision full of nice words, objectives that are not achieved, plans that are constantly being changed, etc. are often the writing on the wall that you are dealing with a value trap. A management that promises little and does a lot, is better than a management that promises a lot and does little.