A value trap is like quicksand for your money.
First your money gets stuck… Then it slowly sinks (in value).
History has shown that buying cheap stocks gives you better returns than buying expensive stocks over the long term. But in order to get those returns, you have to be sure that "cheap" is not a permanent state of affairs.
If it is, you won't be getting the return you expect. And you might not get any return at all. Your money will just be stuck… and slowly sink in value.
Today, I'll discuss how to know if a stock is really cheap… or if it's just a value trap.
Whether a stock is cheap or expensive depends on its valuation… not on the share price itself.
A stock that trades for only $1 can be expensive if it trades at a high valuation. And a $100 stock can be cheap if it trades at a low valuation.
We can measure a stock's valuation in a number of ways. You've probably heard of two of the most popular methods to value a stock – the price-to-earnings (P/E) ratio and the price-to-book-value (P/BV) ratio.
These involve looking at the fundamentals of a company – things like how much they earn, how much they sell, and how much debt they have – and measuring them against the market price of the stock.
Of course, a stock's valuation has many ingredients. And if you dig deeper, a cheap-looking stock might not always be as cheap as its valuation suggests. Bad management, deteriorating assets, product obsolescence, a long track record of poor capital-allocation decisions… All of these are the ingredients of a value trap.
One kind of value trap to watch for is an earnings-driven value trap.
This happens when a stock seems cheap because it has a low P/E ratio (calculated as the price of the stock divided by the earnings per share). But if earnings keep falling, the P/E ratio will climb.
For example, if a stock is trading at $5 per share, and its earnings are 50 cents per share, it will have a P/E ratio of 10. But if the share price stays the same and earnings drop to 35 cents per share, the P/E ratio would climb to more than 14. That's a lot less cheap.
Investors tend to fall into this trap when a stock's price falls slightly. It looks cheap. But then earnings drop, and what was cheap is now less cheap – even though the stock price hasn't moved up. Then earnings decline again, and what once looked cheap is now downright expensive because earnings have fallen so much.
Now, a value trap can stop being a value trap – and become an attractive, undervalued investment – if something changes. New management, a big shift in the industry, higher commodity prices, a regulatory change… All of these things can turn a value trap into a great investment.
How can you avoid value traps? For starters, don't invest just because valuations seem low… They might have been low for a long time. Don't necessarily take valuation metrics at face value.
When you're gauging a company's true value, here are a few questions to ask yourself…
First, how is the company's debt profile? You want to avoid companies that are loaded with debt.
Second, is revenue growing? A company that isn't generating more in sales every year will have a difficult time earning more money every year.
Third, is the industry or sector as a whole growing? If not, that's another reason a company might have a difficult time increasing revenues and earnings.
Finally, does the company operate in a cyclical industry (like commodities, for example)? If so, you'll need to time your purchase so that you don't get sucked into a value trap.
And if the company is in what's called a "structural" decline – which can happen after a fundamental shift in a business or industry – it can mean that demand for the business, and sometimes the industry, will never recover.
In short, cheap is usually good. But not always. Value traps can punish your portfolio even more than buying a stock that's too expensive in the first place.
Editor's note: Finding cheap, profitable investments is crucial in the stock market… and the real estate market, too. Kim's colleague Peter Churchouse made a fortune with great deals in real estate – and now, he's publishing his secrets. Steve says this book is a "cult classic in the making." But you won't find it on Amazon or in bookstores. To learn how to claim your copy, click here.