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In Wall Street circles, a “value trap” refers to a situation where investors are drawn to a particular stock because its price appears to be very low, often with seemingly attractive metrics such as a low price-to-earnings (P/E) ratio or price-to-book (P/B) ratio. However, more times than not, many amateur investors fail to understand that there is often a good reason for the low price, such as poor fundamentals or slowing earnings growth. In a value trap, though the price seems low already, the fundamental issues continue to erode value over time, though they once appeared to be a bargain. Avoiding value traps requires an investor to look beyond a low valuation ratio and consider other factors. Below are 3 signs you may be in a value trap:
The Company has “Caretaker Management”
When a company has a long and successful past, management may fall into the “caretaker” trap. In other words, the company has so much cash on hand, and executives get paid such large salaries that there is little motivation to grow the business. For example, in 2022, AT&T ((T - Free Report) ) CEO John Stankey hauled in more than $20 million in total compensation. Meanwhile, AT&T’s EPS fell from 2.63 to 2.57 per share during the same time. In fact, AT&T’s earnings have stagnated for years.
Image Source: Zacks Investment Research
Stick to companies that are constantly innovating, such as Apple ((AAPL - Free Report) ). Though Apple is a massive company, management is always searching for opportunities. Since 2016, AAPL has nearly tripled its annual EPS by innovating and unveiling new products such as the Apple Watch and the wildly popular AirPods. In the long run, the price of a stock is directly correlated to earnings growth.
Dividends May Lure You In
Stocks like Verizon ((VZ - Free Report) ) pay healthy dividends (7.7%). While a 7.7% dividend may be attractive to income-focused investors, investors need to remember that dividends are not paid out in a vacuum. In other words, if a stock is plummeting, even a high dividend will not lead you to profitability. For example, though Verizon’s dividend has increased over the past five years, the stock is down 42%.
Image Source: Zacks Investment Research
Not only would you be lagging if you were in a stock like VZ over that period, you would also have the added insult of injury of opportunity cost. For instance, the Nasdaq 100 is up 44.3% over the same time.
You’re in the Wrong Market Environment
From a total-return perspective, non-value stocks tend to outperform value stocks. Below is the SPDR S&P 500 Value ETF ((SPYV - Free Report) ) versus the S&P 500 Index:
Image Source: Zacks Investment Research
Nevertheless, there are times (such as 2022) when value stocks are in play. Now is not one of those times.
Image Source: Zacks Investment Research
Remember, value stocks are beholden to the market environment like any other stocks.
GARP is The Solution
A GARP (Growth at a Reasonable Price) Strategy can help investors avoid value traps by balancing growth potential and valuation. Warren Buffett holding Occidental Petroleum ((OXY - Free Report) ) is a great example – the company has a history of strong earnings growth and a reasonable valuation.
Image Source: Zacks Investment Research
Image Source: Zacks Investment Research
Conclusion
Sometimes, when you pay for a “cheap stock,” you get what you pay for. Caretaker management, slow growth, and the wrong environment could mean you’re in a classic “value trap.” Use a GARP strategy to balance growth and value and get the best of both worlds.
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3 Tips on How to Steer Clear of "Value Traps"
What is a “Value Trap”?
In Wall Street circles, a “value trap” refers to a situation where investors are drawn to a particular stock because its price appears to be very low, often with seemingly attractive metrics such as a low price-to-earnings (P/E) ratio or price-to-book (P/B) ratio. However, more times than not, many amateur investors fail to understand that there is often a good reason for the low price, such as poor fundamentals or slowing earnings growth. In a value trap, though the price seems low already, the fundamental issues continue to erode value over time, though they once appeared to be a bargain. Avoiding value traps requires an investor to look beyond a low valuation ratio and consider other factors. Below are 3 signs you may be in a value trap:
The Company has “Caretaker Management”
When a company has a long and successful past, management may fall into the “caretaker” trap. In other words, the company has so much cash on hand, and executives get paid such large salaries that there is little motivation to grow the business. For example, in 2022, AT&T ((T - Free Report) ) CEO John Stankey hauled in more than $20 million in total compensation. Meanwhile, AT&T’s EPS fell from 2.63 to 2.57 per share during the same time. In fact, AT&T’s earnings have stagnated for years.
Image Source: Zacks Investment Research
Stick to companies that are constantly innovating, such as Apple ((AAPL - Free Report) ). Though Apple is a massive company, management is always searching for opportunities. Since 2016, AAPL has nearly tripled its annual EPS by innovating and unveiling new products such as the Apple Watch and the wildly popular AirPods. In the long run, the price of a stock is directly correlated to earnings growth.
Dividends May Lure You In
Stocks like Verizon ((VZ - Free Report) ) pay healthy dividends (7.7%). While a 7.7% dividend may be attractive to income-focused investors, investors need to remember that dividends are not paid out in a vacuum. In other words, if a stock is plummeting, even a high dividend will not lead you to profitability. For example, though Verizon’s dividend has increased over the past five years, the stock is down 42%.
Image Source: Zacks Investment Research
Not only would you be lagging if you were in a stock like VZ over that period, you would also have the added insult of injury of opportunity cost. For instance, the Nasdaq 100 is up 44.3% over the same time.
You’re in the Wrong Market Environment
From a total-return perspective, non-value stocks tend to outperform value stocks. Below is the SPDR S&P 500 Value ETF ((SPYV - Free Report) ) versus the S&P 500 Index:
Image Source: Zacks Investment Research
Nevertheless, there are times (such as 2022) when value stocks are in play. Now is not one of those times.
Image Source: Zacks Investment Research
Remember, value stocks are beholden to the market environment like any other stocks.
GARP is The Solution
A GARP (Growth at a Reasonable Price) Strategy can help investors avoid value traps by balancing growth potential and valuation. Warren Buffett holding Occidental Petroleum ((OXY - Free Report) ) is a great example – the company has a history of strong earnings growth and a reasonable valuation.
Image Source: Zacks Investment Research
Image Source: Zacks Investment Research
Conclusion
Sometimes, when you pay for a “cheap stock,” you get what you pay for. Caretaker management, slow growth, and the wrong environment could mean you’re in a classic “value trap.” Use a GARP strategy to balance growth and value and get the best of both worlds.