How to Spot a Value Trap Investment

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How to Spot a Value Trap
Investment

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Over the years we have often
cautioned investors to beware of
penny stocks, especially those that
have seen better days.

While investing in a grand old name
in hopes of a recovery it is important
to learn how to spot a value trap
investment.

This issue came up recently when we
wondered what was wrong at
Kraft Heinz.

As bargains become harder to find in
an aging bull market there is a
temptation to go bottom feeding in
search of an investment miracle.

Here is some advice about what to
watch out for.

Kraft Heinz Products

Spotting a Value Trap

A couple of years
back Bloomberg published a useful
article with 12 signs a cheap stock
is a value trap.

The historically high price-to-
earnings ratios being placed on
equities today make cheap stocks
even more alluring.

That makes sense, but be advised that
the market is littered with “value
traps” or stocks that look cheap but
never substantially rebound.

Any way you cut it, value is
profoundly out of favor, and not just
in 2017.

Although proponents of these
investments typically are patient
people, the long-term differential is
large enough to be worrisome.

Over the last 10 years, growth has
outperformed value by more than
100 percent in small caps and by 50
percent in large caps.

Thus, knowing how to spot a value
trap is doubly important at this time.

Here are dozen suggestions
from Bloomberg.

The ideas are theirs but rewritten by
us for the sake of brevity.

Still Troubled at the Top
of Its Operating Cycle

The U.S. economy and the vast
majority of stocks have long recovered
from the 2008 stock market crash and
financial crisis.

If the company you are looking at is
performing poorly in the best of times
it may well be a value trap.

Something is wrong as is not being
fixed or cannot be repaired.

Low Profits but High
Management
Compensation

When a company falls on hard times
it typically puts the screws to
management by cutting salaries and
tying compensation benefits to
performance.

When this is not the case,
management is milking the company
for every last dollar before bailing out.

This is a strong sign of the stock being
a value trap.

Lack of Fresh Insights

When an industry like the U.S. auto
industry is centered in one city or area
like Detroit, everyone works with and
socializes with like-minded people.

But, when fresh ideas are needed this
can be a real hindrance and create
value traps of otherwise strong
companies.

Market Share Continues
to Slip

When someone else starts taking
market share away from an old
stalwart, you need to see them
fighting with all that they have to
regain that share and succeeding.

Otherwise, they have become a value
trap.

Too Many Fingers in the
Pie

Many times a well-established
company has many stakeholders such
as labor unions, foundations, or old
family control.

The goals of these folks may not be
consistent with a good return on
investment by those who hold their
stock.

Consider such companies to be value
traps until proven otherwise.

Not Managing Capital
Effectively

A company that has historically been
a cash cow may have gotten by for
years by just putting money in the
bank instead of reinvesting in R&D,
acquisitions, and the like.

When this company starts to slip it
needs to shift gears or it is a value
trap.

And, the changes in how they manage
capital need to be clearly articulated
to investors and need to begin to show
results.

Fat and Inefficient
Management Structure

It is said that when Sears built the
Sears Tower that they took up 22
floors for management, each floor a
different level.

No one was paying attention to how
management was being carried out
and no one was making changes.

When a company does not upgrade
and modernize how it operates on the
day by day and decision by decision
level, it becomes a value trap because
its competitors will outperform it
every day of the year.

Unrealistic and Fantasy
Management Goals

When a company is in trouble it needs
to regroup and it needs to explain
those plans to both employees and
investors.

When management’s new goals are
simply unrealistic no good will come
of them.

You can often see this by looking at
old financial statements and the goals
articulated in previous years and the
fact that nothing useful has happened,
ever!

This situation is a clear sign that the
company is a huge value trap.

The better situation is when
management promises a little but
delivers a lot on a recurring basis.

Too Much Debt

The final nail in the coffin of most
struggling companies is that they
cannot pay their mounting debts with
their dwindling cash flow.

No matter how hard they try, how
creative they are, and how much they
economize, excessive debt is a killer
and makes a stock a value trap.

Muddled Thinking and
Poor Insight

The so-called strategic vision or the
company is all muddled or simply
lacking.

When management’s plans for the
coming years ramble on and repeat
themselves, it is time to consider that
stock a value trap, absorb your losses,
and move on.

Split Attention between
CEO and Board Chairman
Responsibilities

When it is time to turn around a
failing company it takes all of the time
and attention that the CEO has.

When he is spending a third of the
time answering to the board of
directors when he or she should be
making changes from the ground up
that is a sign of impending failure.

Turnarounds need the full attention
of the CEO or they become and
remain value traps.

The Takeover Activists
Are Nowhere in Sight

When a company has been
mismanaged but has a lot of hidden
value, there is always a Carl Icahn or
his clone interested.

When nobody shows up, that is a clear
sign that the company really is a value
trap and you should avoid it as well!

How to Spot a Value Trap
Investment

The tips provided by Bloomberg are
useful in spotting and avoiding a
value trap.

They all fall into the categories
of fundamental analysis and
evaluation of intrinsic stock value.

While growth stocks have been
leading the market in the last few
years, there is a definite place for
value in your portfolio.

The trick is recognizing true and
lasting value in an investment by
understanding and appreciating how
a company makes its money and how
it will continue to do so well into the
future.

Eastman Kodak

How to Spot a Value Trap Investment

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