What Is A Value Trap?

With this week’s [Friday] subscriber request video I will be examining the difference between a value trap and an opportunity. In my experience, most investors in stocks take their lead from stock price movements while simultaneously either overlooking or simply ignoring fundamental values.

Therefore, with this video I will attempt to clearly illustrate the primary difference between a true value trap versus a value stock. The former represents a disastrous investment while the latter represents not only extreme opportunity, but opportunity at significantly reduced risk. The idea of higher returns at lower risk is perhaps the greatest promise of value investing.

The following quote by renowned investor Marty Whitman of the Third Avenue Value Fund highlights an important distinction that needs to be made regarding a value stock versus a value trap:

“Unrealized Market Depreciation occurs when the market price of a publicly traded security declines. Permanent impairment of capital occurs when the Fundamental values of a business are dissipated with the consequent long-term adverse consequences.”

The free dictionary by Farlex defines a value trap as follows and validates my opening statement:

“Value Trap

A stock with a lower-than-usual price that appears to be a value stock but is not. A value trap appears to be undervalued at first glance but its fundamentals are unhealthy and the stock is unlikely to recover in price. One may fall into a value trap by looking only at the stock’s price but not at any other financial information.”

To summarize, value investing is a proven investment strategy that both reduces risk and enhances long-term rates of return. However, for value investing to be successful, value investors must recognize and embrace the reality that short-term performance might not always be attractive. The reason for this is very simple. Almost by definition a value stock is simultaneously out of favor.

Furthermore, as a result of being out of favor it is not uncommon to continue to see value stocks continuing to fall in the short run. The trick is to determine whether the negative price reaction is justified or overdone. With true value investing the value investor discovers strong businesses where the market has overreacted and driven their prices down to attractive levels.

Credit Suisse Group (CS), Harsco Corp (HSC), Pitney Bowes (PBI), Canon Inc (CAJ), Brinker International (EAT), Cigna Corp (CI), Affiliated Managers Group (AMG), Prudential Financial Inc (PRU), International Business Machine (IBM).

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— Chuck Carnevale

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