Value Investing is all about identifying stocks with unidentified or underappreciated potential and waiting for that value to be realised over time. However, it’s always worth remembering that some stocks are cheap for a reason. Of course, we all hope that the market will come to recognise what a bargain our latest investment was. But, every now and then, a price fall may lure you into every value-investor’s nightmare – a false bargain, better known as a value trap.
What is a Value Trap?
A value trap is a company that appears cheap because of a large price fall, but which is actually still expensive relative to intrinsic value. In effect, it is masquerading as a value stock. It looks like a bargain price because it has come down so much but, despite the allure of a low price, a value trap’s price is low for a good reason – unlike a true value stock, these companies are experiencing a fundamental change in their business prospects and could basically dying companies. As Warren Buffet said, “price is what you pay, value what you getquot;.
Timothy Fidler of Ariel Focus suggests that there are two main types of value traps:
Earnings-driven value trap – This…
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