Value Traps vs. Bargains -- How to Spot the Difference

The old adage “You get what you pay for” is one we've heard all our lives, probably since we were first introduced to money.

The usefulness and everyday applications of this saying simply know no bounds. Don't want to pay a lot for a used car? Don't expect warranties, service and other luxuries and be wary of getting a vehicle that may barely be operational. Want to save a lot of money on your next round of golf? Great idea, but don't complain if the $10 course you choose to play at is right next to the freeway. The point is, just because something is cheap, doesn't make it good, and nowhere is that more true than in the world of investing.

Many investors look at a stock's price and use that is an indicator of how expensive or inexpensive the shares are. This is a mistake unto itself, but let's talk about another grand mistake that investors of all levels frequently make: Falling into a value trap.

A value trap is the purchase of shares in a stock that is badly beaten down on the premise that they are "a bargain" and/or aren't likely to fall any further. Obviously, value traps are laid out by stocks that have experienced dramatic declines. Investors get lured in, thinking they've found  a bargain, only to find there is more downside to come.This situation is called a value trap because investors think they're getting a steal on a great company.

Value stocks should not be confused with value traps. Value stocks are blue chip names that investors can normally feel safe about owning, even over long-term time frames. They generate smaller returns than growth stocks, for the most part, but their performances are fairly predictable and most value names pay dividends. Every investor should own at least a couple of value stocks, but we all should avoid value traps.

Let's take a look at what we need to watch for when it comes to value traps.

The Rain Doesn't Want To Stop Falling...
Here's the problem with buying shares of a stock that is rapidly declining -- it's a lot like trying to catch a falling knife. [To learn what we mean by "catching a falling knife," click here to read Dead Cat Bounce -- 10 Strange Investment Terms Explained.]

Let's put it this way, if Company XYZ was trading at $60 in June, but trades at $35 in September, an investor may think this is a value opportunity. Well, it may be. That said, there may be nothing to stop this stock from going to zero. You need to examine the fundamentals to find the answer.

That's the essence of a value trap. A stock that was formerly beloved or used to be a great company now appears cheap and sucks investors in. The sucking effect on your money is like that of a black hole.

Don't Be Fooled By Price Alone
As we noted earlier, price often times is the deciding factor for an investor's purchase of a particular stock. This can be a mistake because ABC Co. and XYZ Inc. may operate in the same sector, doing the exact same things, while ABC trades at $30 and XYZ trades at $40, but XYZ could actually be the less expensive name. XYZ could be undervalued at $40 while ABC could have black clouds looming and $30 could represent far too rich of a valuation for the stock.

There are dozens of methods to value a stock, such as free cash flow, trailing earnings, forward earnings, price-to-sales, dividend yield, price-to-book value and on and on. All price represents is a number for the marketplace to put on the stock so buyers and sellers can efficiently do business.#-ad_banner_2-#The primary difference between a Value stock and a value trap is that the former will eventually turnaround. There is some catalyst, be it in the former of good earnings, new products, insider buying, etc. that compels people to buy the shares. A value trap lacks all of those features. Value traps typically have no good news to speak of and company executives definitely aren't buying the stock. In fact, they're probably dumping it. Value traps also have cash flow problems from high debt or excessive dividend payouts or both.  These are the traits to look for so you can avoid a value trap.

If you want to learn more about avoiding value traps, click here to learn One Way to Catch a Falling Knife.

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