In your quest to gain financial independence and wisdom, you’ll likely encounter the term “value trap” to describe certain stocks, industries, or situations.
On the other hand, a bad luck may come not only to the small business, but also the biggest business. Being aware of their existence can help you better manage your portfolio risk. Also, avoiding situations that might otherwise tempt you to do something foolish.
What a Value Trap is
A value trap refers to a situation that, on the surface, appears to offer an investor the opportunity to acquire significant assets and/or earnings relative to market price.
It also promises a chance at much higher-than-average profits than the broader stock market. But, it turns out to be illusionary due to any number of factors.
The Causes of the Development of a Value Trap
There are two reasons of the development of a value trap. First is about a permanent change in the cash generating power of a firm or industry. It leads to the past comparisons of little use.
Take an example, Henry Ford began production on the Model T automobile. If you saw the price decline, looked at the past net income, and thought, “Oh boy, this is cheap compared to fundamentals!” means that you were very mistaken. The past operating results of the business were of limited use in determining its intrinsic value.
Second is about the cash flow issues are more severe than the income statement alone indicates. Take an example, in the 2008-2009 Great Recession, several lucrative financial institutions, including a handful of the world’s major investment banks, had their common stockholders wiped out.
There was a mistake in capital structure that spells certain economic death when the world falls apart. The mistakes are just the same as you don’t learn from the past lessons.
As a result, if analysts expect sales to decline below this threshold for some reason or another, a 20% decline in revenue can translate into an 80% decline in profits. In still other situations, a firm might be doing fine but capital market conditions are difficult or a huge corporate bond issue is coming up for maturity and there is doubt about the firm’s ability to refinance.
How to Avoid a Value Trap
One classic example of doing your homework to find that what appears to be a value trap is not, in fact, a value trap is the American Express salad oil scandal of the 1960’s.
A young Warren Buffett made a lot of money. Buffett made a lot money that went on to serve as the basis of his Berkshire Hathaway fortune. By calculating the maximum potential damage the credit card company would face if everything possible went wrong, realizing investors had become too pessimistic. Therefore, the business would be fine.