Absolute bargain or cheap for a reason? How to spot a value trap

Everyone loves a bargain and investors are no exception. Indeed, the world’s greatest stock picker, Warren Buffett, once devoted his time looking for battered stocks that he could buy cheaply and eventually make a profit on.

Unfortunately, ‘value investing’ — or buying stocks for lower than their intrinsic value and waiting until their stock prices correct — is harder than Mr Buffett made it look with many ‘bargain’ stocks turning out to be absolute dogs for their holders. Here are just a few ways of spotting and avoiding them.  

1. Sky-high dividends

Chunky dividends attract investors like moths to a flame. However, as holders of stocks like Centrica and Royal Mail will know, a big yield is often a sign that the market has lost confidence in a company, earnings are floundering and a cut is just around the corner.

How high is too high? It’s subjective but I’d say anything yielding above 5% requires extra scrutiny. It’s particularly important to check the extent to which dividends are covered by profits (found by dividing earnings per share by payout per share). Anything less than 1.0 should usually be avoided. Dividend cover of 2.0 or more is ideal. 

2. Susceptible to disruption

A company that struggles to compete with newer, nimbler rivals could continue falling in value regardless of how cheap its shares already are. 

A recent example of this would be Thomas Cook. The one-time FTSE 100 member didn’t adapt quickly enough to the fact that only a minority of people physically enter a travel agent to book a break these days. 

If you can’t identify a reason as to why a company will be able to stay relevant and grow profits over the years, then steer clear.

3. Too much debt

Even if a company can still hold its own, too much debt on its balance sheet — perhaps as a result of acquisitions in an effort to boost earnings — can be enough to kill it. This clearly becomes even more likely in the event of a sustained economic downturn.

Before buying into any stock, check its balance sheet and ask yourself whether you’d feel comfortable owning the shares during a recession. Anecdotally, the vast majority of stocks in my own portfolio have net cash positions, which should help them negotiate tough times without issue. 

4. A favourite with shorters

Generally speaking, it’s best to disregard stocks attracting the attention of short-sellers. Based on their usually-very-intensive research, these people are betting big money that the share prices of particular companies will continue falling, at least over the short term. 

There have been many examples this year in which the shorters have got things right: battered challenger Metro Bank, services provider Kier Group and the aforementioned Thomas Cook. All of these were ‘cheap’, based on conventional metrics.

Checking shorting activity isn’t difficult. Simply go to shorttracker.co.uk and enter the relevant ticker.

Price isn’t the most important thing

On their own, each of these indicators might not be sufficient to identify a value trap. Collectively, however, the chances of big trouble rise significantly.

That’s why I’m a big fan of star fund manager Terry Smith’s approach. While not dismissing the importance of buying at a good price, Smith feels identifying great companies is more important. With his Fundsmith Equity Fund having achieved an annualised return of 18.8% since inception, it’s hard to disagree.

Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.