With the market trading at valuation ratios not seen since the pandemic, bargain hunters are starting to cautiously enter the market and pick up stocks perceived to be trading at “cheap” valuations.
The general assumption is that it is safe to accumulate a stock if it’s trading at its 52-week low—but wait, it could be a trap! Not every “cheap” stock is worth picking up, especially if it has been cheap for the longest time.
These stocks are what we call value traps, which refer to a stock that appears to be a great bargain due to low valuation metrics, either price-to-earnings (P/E) or price-to-book (P/B) ratios, but is actually a poor investment choice because of underlying issues with the company.
As we have said in a previous column, we need to go beyond surface-level analysis to really understand the overall condition of the company. In this case, we need to look at the bigger picture and put these valuations into a broader historical context.
How can we identify these value trap stocks? A value trap can be identified by extended periods of consistent price decline and low multiples. It is normal for valuation ratios to swing within a range, usually as a response to broader market movements.
However, it is not normal for valuation ratios to consistently decline or stagnate near their lows. This is usually the first warning sign of a value trap and could indicate that the stock has little hope for recovery.
To illustrate this concept, we will be anonymously naming a couple of examples of these so-called value trap stocks.
The warning signs
Over a 10-year time frame, these two stocks have been consistently setting new all-time lows and have been trading at extremely cheap valuations for an extended period, regardless of periodic upticks in the broader market.
Stock A was trading at 24x P/E in 2015, but it is now trading at around 3x P/E, which makes it look like a good buy. (Editors' note: P/E or price-to-earnings ratio measures how much investors are willing to pay for a company’s earnings—higher means pricier, lower can signal a bargain or a risk.)
However, if one looks at the 10-year chart, it would show that this stock has been trading within the range of 2-4x P/E since 2020. The timing indicates that this could be a company that never really quite recovered from the disruption of the COVID-19 pandemic. It doesn’t help that one of its key business units is considered a sunset industry—one that is in decline.
Stock B, on the other hand, was trading at a 1.5x P/B ratio in 2015 and was considered one of the leaders in its industry. (Editor' note: P/B or price-to-book ratio compares a stock’s market price to its book value—low P/B can mean undervaluation or trouble, while high P/B suggests strong growth expectations.)
Patterns to watch
However, its price has consistently declined since then, and its valuation has remained within the 0.2-0.3x P/B range since 2022.
A high-profile company like this should not be trading at such levels, and that should be the first warning sign. This company operates in an industry that underwent a seismic change in 2022, and it was simply not able to keep its competitive edge in the face of this change. Because of this, the company is now stuck with a massive inventory that will take years to clear.
Think before you buy
Most value traps, like these two, are hidden in plain sight and can snare both new and experienced traders. However, they can easily be avoided if you know how to identify them.
We are big fans of bargain hunting, but we believe it should be done methodically, and one should not be fooled by the big red “50 percent off!” tag. Sometimes, it is prudent to pause and ask yourself: if it’s cheap but nobody is buying it, why should I?
Financial market recommendations and comments on InsiderPH News belong solely to the analysts and institutions making them. They do not represent buy, sell or hold recommendations of InsiderPH News. Investments held by analysts or institutions may influence their recommendations. Investors should conduct their own research and carefully evaluate all relevant market information before making investment decisions. As always, the past performance of any investment does not guarantee its price appreciation in the future.
