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Why cheap stocks are not always the best kind of investments

·5-min read

My friend called me the other day. ‘’I think I found some companies available at good valuations. Even though the markets have recovered, they are still trading at a discount to the markets and peers'', he said. ‘’I think they will make for a great investment.’’

My friend here was making a classic mistake. He had gone out bottom-fishing, only to find himself under another trap, commonly referred to as a value trap.

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What is a value trap?

According to Investopedia: ''A value trap is a stock or other investment that appears to be cheaply priced because it has been trading at low valuation metrics." The keyword here is ''appears''.

Even if a company is trading at a discount to its fair value, it might not be an attractive investment. It only ‘appears’ to be one. But you still bet on it. Which means you are buying companies that are out of favour with the market.

Now, in some cases, the pessimism is overblown, and there is a good chance you will make good returns. However, other times this pessimism is warranted, and it could be due to a variety of reasons. Maybe, the company has succumbed to tough competition or is a victim of rapid technological change or is poorly being managed by an incompetent and unethical set of managers.

Whatever the reason, such kind of companies that fail to perform despite their inexpensive valuations eventually becomes value traps.

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A value trap usually attracts bargain hunters, investors desperately looking for turnaround stories

Investors often confuse inexpensive stocks for good value stocks. But you cannot blame them as there is a thin line between the two.

Let us understand this better.

Value investing is built on the premise of spotting a fundamentally strong company available at attractive valuations, a hidden gem so to speak. And you will spot them only if you have done some research on the company. But usually, rather than discovering that hidden gem, bargain hunters end up investing in a dreg. They do not conduct any fundamental background research and base their decision on the bare assumption that the fallen stock will someday recover. It is one of the primary reasons investors get stuck in a value trap and is also the only solution to avoiding one.

Value trap stocks come in all shapes and sizes

Some might be:

dividend paymasters,

too big to fail,

boast a great product or service,

have decent market share even (Jet Airways Ltd.) But despite this, they are majorly lacking in an essential area. So, even though they seem attractive, like a Lehman Brothers back in 2007 or a BHEL at the prevailing prices, they are often not.

Most of the PSU bank sector is sailing in the same boat along with the smaller construction companies. They have piled up on debt and might not be able to make it to the finish line. With such high levels of uncertainty ahead of us, their low valuations might be justifiable, making them an attractive value trap.

The key to avoiding a value trap is fundamental research

While a stock trading at a low valuation can be a great starting point, you cannot let that one factor drive your intent to invest in it.

Every buying decision must be on the back of extensive background research. Start by reading the balance sheet to understand the financial health of the company. Develop a deep understanding of the business to chart out its potential and subsequently, its fair value. It is the only effective way to avoid value traps.

Look for some of these pointers in the discounted company you wish to invest in:

  • A healthy balance sheet. Low levels of leverage, a high debt-equity ratio, high-interest coverage ratio are positive.

  • Strong cash flow from operating activities rather than investing

  • Market leaders in their fields are always preferable. The company should either boast a great relevant product or service. Just steer clear of companies that have been ruined by competition or have outdated products and services.

  • An economic moat. A particular feature of the company that sets it apart or a kind of advantage only this company enjoys; examples include first-mover advantage, economies of scale, extensive distribution network, exclusive rights etc.

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These factors can also help identify companies that can weather any economic crises

Economic crises, like the current Covid-19 ones or the subprime crisis of 2008 are not as uncommon as they might seem. The world has witnessed one almost every decade, for a long time now. And while an economic crisis does present some great opportunities to buy quality stocks at a discount, they are also breeding grounds for value traps.

Amidst an economic crisis, the stocks of the fundamentally weak companies are the first ones to witness a free fall, making them even more attractive to bargain hunters. And usually, these are the ones that have borrowed heavily, hoping to benefit from financial leverage. But rather than successfully taking advantage, most of them eventually drown in their debt much like JP associates, Jet airways etc.

And so when such crisis ensues, investors flock over to the stock market looking for bargains. But often find themselves stuck with poor performers (value traps) that are unlikely to sustain in a bad economic environment. This also explains, why even now, although the markets are touching new highs, a lot of companies are still far from their pre-COVID highs.

As common as value traps are, they only entangle those who refuse to educate themselves. So the key to side-step such traps is research and analysis. Don't be ignorant and do your homework; educate yourself and eventually take calculated risks that match your financial goals. It is by far the most proven strategy to prepare yourself for any kind of value traps.

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