How to identify value traps in stock investing and tips to avoid them

What is the value of a share? Is it the market price at which it is being traded? Or, are there other ways to determine its value? Before you start investing in the equity market, it is important to understand that a share is an ownership in a company and thus, has an intrinsic value.

Hence, one of the most preferred ways of investing is looking for good-quality stocks that are undervalued and holding them for long periods. While this can ensure good returns (even multibaggers at times), identifying undervalued stocks requires a comprehensive understanding of the factors that can help you determine the intrinsic value of the stock.

A small error in this process can lead you to a value trap and diminish the returns or cause potential losses. Let’s look at understanding these value traps and how you can avoid them.

What is value investing and what is a value trap?

Value investing means investing in stocks that are trading lower than their intrinsic value, but offer good potential returns in the long-term.
Determining the intrinsic value requires an analysis of the fundamentals of the company like its financials, management team’s efficiency, profit management, financial records, competition, innovation, etc.

This is way different from a trader who looks to benefit from the volatility in the market price of a stock.

If you analyze the company’s fundamentals comprehensively, you will be able to find stocks that are undervalued as compared to their intrinsic values and invest in them to give yourself an opportunity to earn good potential returns.

However, some investors don’t have the time or inclination to analyze a company and invest in a stock if it is inexpensive as compared to its peers.

These investments turn into value traps as they fail to perform as expected and even lead to losses.

Here's how you can identify such value traps and avoid them:

Management Quality

Management quality is one of the most important fundamentals. The ethics of those who have the reins of the company in their hands must be in order. Has the management taken undue profits out of the company?

Is the top management's salary structure abnormally high? Are there indications of any frauds or bad ethics like insider trading, etc.? Are the reports shared by the company transparent? A quick research on the quality of the management team is critical.

Peer to peer comparison

When you analyze a stock, you should not ignore its peers from the industry. Looking at a stock as a standalone asset can give you misleading results. For example, let’s say that you decide to invest in the shares of ICICI Bank.

You conduct an analysis of the company and feel that it is undervalued. But, unless you don’t compare it with other banks like HDFC, Kotak, Axis, etc., you won’t know if industry-level factors are causing a decline in its performance.
On comparing, if you find ICICI Bank’s performance lacking, then you can conduct a deeper analysis on the factors that are causing the lack of performance.

This will give you a clear picture of whether ICICI Bank’s stock isa value trap or not.

Groww has a list of companies under the subhead 'Similar Stocks' that can help you to have a quick peer to peer comparison. For example, if you are looking at Infosys, then under the ‘Similar Stocks’ subheading, the companies that display are Tata Consultancy Services (TCS), Wipro, Tech Mahindra, Oracle, Mindtree etc.

Declining Market Share

A declining market share is another red flag you need to spot.

The concept is simple but imperative as it speaks volumes of the demand of the company's products/services in the market.

Also, a declining market share of a company is usually accompanied by a drop in its share price that can bring it on the radar of an investor looking for undervalued stocks.

If the general consumer is losing confidence in the company's offerings, the chances of it being a value trap are high.

Narrow Product range:

If the company's product range is extremely narrow and there is overdependence on a certain kind of product, then it can raise a red flag. Diversity helps even out risks.

If the company focuses only on a single kind of product, any disruption can hit the company's stock price really hard.

Since, value investing generates returns over the long-term, looking for companies with a basket of diverse products and/or services can help you avoid a value trap.

Improper use of capital

Let’s say that a company has an efficient management team, scores well against its competitors, has an increasing market share, and a diverse product range.

So far, so good! The next thing that you need to look at is how the company is managing its free cash flow. Once the company deducts the operational and capital expenses from its revenues, the cash left is called free cash flow.

The company can use this money to increase shareholder value or boost its business. Analyzing how a company uses these funds can highlight the areas of focus and help analyze future growth.

A mismatch between promises and delivery

Every company declares its long-term and short-term business goals. Usually, investors look at the value of the company and its future plans before buying its shares.

While setting goals is one thing, achieving them is quite another. A quick look at the past performance of the company can tell you if it has delivered on its promises or not.

While there can be macroeconomic events that might have prevented it from fulfilling some of its goals in the past, if you observe a trend of not living up to the promises, then it might be a value trap.

Knee Deep in Debt

Debt is more like an all-weather indicator for shares. Some debt is essential as it speaks of the company's expansion plans and eagerness to grow. However, too much debt and a history of the inability to repay can be a value trap. You can look at the financial statements of the company to assess its outstanding debts.

Also, a quick look at the debt to equity ratio can tell you how much debt a company is using to finance its operations as compared to the shareholder equity.

A high debt to equity ratio indicates a company that is aggressively funding its growth plans using debt. While this can help boost business, it is a high-risk move and can backfire if market conditions turn unfavorable.

Sudden and Massive Price Drop

If a stock is trading lower than its intrinsic value, then the first thing you need to look at is how the stock landed at that level.

Check if there was a sudden massive drop in price in a short period. Such drops take more time to recover, and investing in such stocks, hoping for a 'V'-shaped recovery in the share market can lead you into a value trap.

Investor pattern

Having institutional investors on board is a good sign as bigger institutions like mutual funds, banks and other big investors have the technical knowledge and expertise to analyze the company before investing in it.

Therefore, if institutional investors are avoiding a company, then you need to be more vigilant with your analysis before investing.

If you are investing in undervalued stocks, then identifying and avoiding value traps is a must.

While the tips mentioned above can help, the core idea is to assess if the company’s stock is selling below a fair value due to it being underestimated by the markets.

It’s not just about buying cheap stocks with decent fundamentals - it’s about buying good-quality stocks with strong fundamentals but undervalued in the market.

Take a bird’s-eye view of the company, industry, and the stock market to avoid falling into a value trap.

Remember, never invest in a company if you are having doubts about its fundamentals. Research thoroughly, analyze well, and make wise investment decisions!

Disclaimer: No Deccan Chronicle journalist was involved in creating this content. The group also takes no responsibility for this content.