Investors sometimes fall prey to so-called value traps when they go hunting for a bargain stock. These "bargains" may appear promising, but they prove to be a big letdown for investors as they don't perform.

In this article, we'll show you how to hunt down a valuable stock without getting stuck in a value trap.

Key Takeaways

  • Value traps are investments that are trading at such low levels and present as buying opportunities for investors but are actually misleading.
  • For a value trap, the low price is often accompanied by extended periods of low multiples as well.
  • A value trap is often a poor investment: the low price and low multiples mean the company is experiencing financial instability and has little growth potential.

The Low Multiple Value Trap

Companies that have been trading at low multiples of earnings, cash flow, or book value for an extended period of time are sometimes doing so for good reason—because they have little promise—and possibly no future.

A terrific example of this type of value trap was found in Rag Shops Inc., a now-defunct company that sold fabric and craft supplies. For years that company traded under or at book value and looked cheap by several measures. Its stock hardly ever budged, causing investor confusion.

The reasons for this stock's deadlock were:

  1. The company had difficulty generating meaningful and consistent profits and was unlikely to generate institutional or substantial retail interest.
  2. Management was reluctant to get out on the road and tell the company's story to retail and institutional investors.
  3. Competition from other craft outlets, including Michael's (and the company it would go on to acquire, A.C. Moore), was extremely stiff, and the company was unable to differentiate itself.

Eventually, the company was purchased by an affiliate of Sun Capital Partners in a $9.2 million deal. Rag Shops ultimately filed for bankruptcy, and investors that were lured in by its once low price-to-book multiple ended up with nothing more than a tax loss.

Lack of Catalysts

Companies and stocks need catalysts in order to advance. If a company doesn't have new products on the horizon nor expects to show earnings growth or momentum of some kind, consider avoiding it.

A company's history should never be overlooked, and it should be compared to what the company's current financial statements look like. If the company cannot improve upon its position operationally, it may have trouble competing with companies that can. Ultimately, the company will probably also have trouble garnering interest from the investment community.

Many seasoned investors and sell-side analysts wait until a catalyst gets ready to hit the market and buy or recommend the stock then. Once the catalysts evaporate or transpire they will jettison the stock.

Multiple Kinds of Shares

Some companies, like Berkshire Hathaway, have Class A shares and Class B shares. The difference between the two classes of stock depends on the situation. Class B shares may contain super (or, advanced) voting rights. For example, one vote of Class B shares might be the equivalent of the votes of five Class A shares. Class B shares may also contain a special dividend or other special rights not granted to the average common shareholder.

The average investor should be wary of investing in a company with two classes of stock. The reason for this is that the owners of the Class B shares generally are insiders or large investors and the company tends to focus on keeping those investors happy rather than paying attention to the common stockholder.

Small Floats

There are many parameters that a company or stock must meet in order for the average institution to take a position in it. Many funds won't take a position in a company unless its stock trades for $10 a share or more. Fund managers and analysts may also be forbidden from getting involved in companies whose annual sales total less than $1 billion or that are unprofitable. Of course, there are usually other prerequisites and parameters as well (for institutional participation) and they usually revolve around a company's float.

Companies with a small float or with few shares that trade in the public domain are unlikely to garner institutional attention because those investors will have trouble acquiring and ultimately disposing of large quantities of stock. When institutions cannot participate in a stock, the shares tend to languish; by extension, they may become a "value trap."

Tightly Held Companies

It is usually a positive sign when insiders at a company own large chunks of their company's stock, as it usually gives those insiders ample incentive to find ways to enhance shareholder value.

Many institutions and entities that can move stocks (i.e., mutual funds and hedge funds) will usually not get involved in a company if it has a high percentage of insider ownership. If insiders own a high percentage of the shares, the investing institution may not be able to influence the board of directors or have a say in corporate governance issues. This lack of institutional interest could cause a stock to seriously languish.

The Bottom Line

Although a company may seem like an attractive investment candidate because of a low multiple, unless it has catalysts on the horizon, interested institutional investors, insider incentives, and ample floats, the stock could lead you into a value trap.