A value trap is like quicksand for your money. First your money gets stuck, then it slowly sinks (in value).
Or better, imagine quicksand that’s covered with a nice picnic blanket, set with the best pizza/chicken and rice/bangers and mash/insert your favorite dish here… and then you clamber over to it. But it turns out that the yummy-looking food is made out of plastic… and worse, now you’re stuck, and sinking into the quicksand.
In investing terms, that’s a value trap.
History has shown that buying cheap stocks gives you better returns over the long term, than buying expensive stocks. But in order to get those returns, you have to be sure that “cheap” is not a permanent state of affairs.
If that’s the case case, 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.
A brief primer: How to know if a stock is really cheap
Whether a stock is cheap or expensive depends on its valuation, not on the share price itself. A stock that trades for only a dollar can be expensive if it trades at a high valuation. And a hundred dollar stock can be cheap if it trades at a low valuation.
There are a number of ways to measure a stock’s valuation. We’ve previously discussed two of the more popular methods to value a stock – the price-to-earnings ratio (P/E) and the price-to-book-value ratio (P/BV). 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, there are a lot of ingredients to a stock’s valuation – and reasons why a cheap stock might not be as cheap as its valuation suggests. Bad management, a long-term track record of poor capital allocation decisions, deteriorating assets, product obsolescence, all of these are the ingredients of a value trap.
An earnings-driven value trap happens when a stock seems cheap because it has a low P/E ratio (calculated as the price of the stock divided by the amount of earnings per share). But if earnings keep falling, the P/E ratio will climb. For example, a stock trading at US$5 per share, with earnings of 50 cents per share, 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 over 14. That’s a lot less cheap.
Investors fall into this trap when a stock price falls slightly, and the stock 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.