Learn with ETMarkets: Top 5 ways retail investors can avoid value traps

Excited about discovering a share with low PE or book value multiples? Beware because it could be a ‘value trap’. Value investing is popular, but it can also lead to traps.

Low prices are different from excellent value stocks. Investors who pursue only stock prices irrespective of the underlying factors will likely fall into a trap.

What is a value trap?
A value trap is a stock or asset that seems to be cheaper as it has been trading at low P/E (low price to earnings), P/CF (price to cash flow) or P/B (price to book value) for a long time.

They are companies that seem to be undervalued, but their stock prices aren’t likely to increase. Many times, these firms are in declining industries or have poor fundamentals.

Value traps can be challenging to spot, but due diligence can help to avoid them. If one takes the time to understand a company and its business, one can protect themselves from these risky investments.

Here are 5 indicators to avoid value traps

1) Management rarely keeps its promises
Every company's management declares its short-and-long-term goals. However, they often fail to live up to their promises. Over-promising and under-delivering are key indicators that the investment is a value trap.

So, how does one avoid it?

One can review annual reports and promoter interviews and look for business goals and achievements. If they are lagging, then there is a problem. Look for businesses that under-promise and over-deliver.

For instance, the management of Suzlon kept promising a better future for its shareholders, who had been losing money for more than a decade when the stock’s CAGR returns were 7-10% negative over 5-10 years.

In the recent period, the stock has improved as the company emerged from a debt restructuring exercise two years back.

Jaiprakash Associates is another example that failed to deliver on its promises, and the stock has performed poorly i.e. negative CAGR of 15-20% in the last 5-10 years.

2) Cash flows aren't keeping pace with earnings or earnings growth is sub-optimal
A value trap could also be a company whose cash flow isn’t in line with earnings or is suffering from suboptimal earnings growth.

It can mean the company is not generating enough cash to fund its operations and growth. As a result, it may eventually resort to selling-off assets, taking on debt to stay afloat, or consistently raising capital through equity offerings.

For example, in the case of Bosch, the growth in OCF/FCF in the last 10 years is far lower than the PAT growth, which in itself is just 1% resulting in a stock price CAGR of just 6%.

Incidentally, the CAGR over the last 5 years has been -5%. Other examples include NTPC and Glaxosmithkline Pharmaceuticals, where the CAGR stock returns range between 2-4% in the past 10 years. In comparison, Nifty50 delivered a CAGR growth of approximately 12% over the past 5 and 10 years.

3) Inefficient capital allocation
Another crucial indicator of a value trap is inefficient capital allocation. It means that the company is not using its capital in a way that will generate shareholder value.

For example, a company may allocate funds towards unrelated diversification or non-core businesses. This is unhealthy for Return On Capital Employed (ROCE).

During the last couple of decades, multiple instances were observed where businesses experimented with unrelated diversification and struggled. Unitech (a real estate firm) forayed into telecom.

Over time, it was saddled with debt and had to sell its entire stake to Telenor. LIC Housing Finance had lent as high as 7% of its overall loans to the project loan segment, whereas other better-managed HFCs have kept this at sub 1%.

The resulting impact has seen GNPA in the project loan segment swell to an extremely high level of 35%, leading to low profitability and, consequently, a 5 years stock price CAGR of 8% and a 10-year CAGR of just 5%.

A few other examples include Vedanta and Tata Motors, where the CAGR returns delivered were in the range of -3% to +5% in the last 5-10-year period.

4) Over-dependence on a specific product or market cycles
Over-dependence on a particular product or market cycle is one of the most significant signs of a value trap. If a company relies too heavily on one product or market to stay afloat, it may run into trouble in the future if the demand for that product begins stagnating or falling.

As a result, it can lead to financial problems and even bankruptcy. Castrol for example heavily relied on a single product, which has resulted in negative stock returns in the past 10 years ( -9% CAGR).

Over-dependence on market cycles can also mean a decline in a company’s business as the cycles are constantly changing.

Coal India is a good example. The company hasn’t performed over the long term, yielding negative 5% CAGR returns to its investors.

An industry that was once booming could eventually become stagnant.

Interestingly, the P/E ratio of cyclical stocks may be low at the peak of their cycle thanks to their historical growth rate and hence seem undervalued. Therefore, an investor may also have to check for the PEG ratio.

5) Falling market share
Falling market share is one of the chief indicators of a value trap. If a company loses market share to its competitors, it may be in trouble as its consumers could be moving away.

Falling market share and declining sales margins can also signify that a company is losing its competitive edge.

For instance, Symphony has been consistently experiencing a decline in its market share, which has also adversely impacted its share price performance in the last five years (-8%), even though the 10-year CAGR still looks reasonable at 15%.

Hero MotoCorp is another example of a low industry growth rate coupled with the emergence of new brands giving a dent to market share, resulting in only 4% CAGR in 10 years and -7% CAGR in the last five years.

Conclusion
There are a few ways to avoid value traps. First, research the company thoroughly before investing. Understand the industry it is in and its competitive landscape. Next, look at the financials and make sure they are strong.

The historical performance of a seemingly valuable opportunity or its industry peers or other names displaying similar attributes in the past but turning out to be duds should give enough confidence of which way this one could turn out to be.

Also, pay attention to what the key management personnel are doing. If they are selling their shares without any apparent reason, it may be a sign that the company is not as healthy as it appears.

(The author is CIO, Research & Ranking)

Note: Stocks mentioned here are just for educational purposes and should not be construed as recommendations

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)