What is a Value Trap?

Be aware of the value trap in today’s market. Many bulls argue that the market is cheap, and that there are undervalued companies across the spectrum. According to fundamental analysis, these bulls are largely right, as many companies do indeed have balance sheets that scream undervaluation.  However, in several instances, companies are only cheap because investors have anticipated low earnings and growth and sold off company stock.

A value trap occurs when a company has strong financials, but weak growth or deteriorating senior management. Wall Street Bean, a blog on the StockTwits network, learned a value trap lesson when they bought into Research In Motion ($RIMM) last year. They say:
Research in Motion has been a great case study for us in value-trap investing. Having actual dollars on the line sucks when learning these lessons, but it makes one reflect more honestly on the mistakes. The giant error we made on RIM was focusing too much on price ratios and balance sheet (and their affect on RIM’s perceived value), and too little on their growth rates over the last few years.
We’re always looking for ways to hone and sharpen the BeanScreen into a better investing tool. Starting this month, we’ve begun to lend more weight to a company’s Growth Rates metrics. Growth rates now comprise 25% (was 20%) of a company’s overall “fundy score”. In doing so, we hope to avoid possible value-trap scenarios.
Uploading the latest numbers into the BeanScreen, we find RIM showing decent overall fundamentals, but the trend is definitely down. Though valuations look attractive on the surface, growth rates are anemic and margins are contracting.

 

The below chart is from Ycharts and represents $RIMM. The blue line is the share price, the red line is the book value, and the orange line is revenue growth.  From a value perspective, $RIMM looks mighty attractive, as its market cap is below the reported book value. However, revenue growth is plummeting, as the company is losing market share to other competitors.  In this sense, RIMM may also be a value trap. Whether it is a value play or a value trap is for you to decide. The point of this post was simply to promote awareness so that no new investors or traders get caught in value traps.


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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