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

Not all bargain stocks are what they seem. Paul Summers picks out four things investors should be looking for.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

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.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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.

More on Investing Articles

Investing Articles

Could the JD Sports Fashion share price double in the next five years?

The JD Sports Fashion share price has nearly halved in the past five years. Our writer thinks a proven business…

Read more »

Bus waiting in front of the London Stock Exchange on a sunny day.
Investing Articles

If interest rate cuts are coming, I think these UK growth stocks could soar!

Falling interest could be great news for UK growth stocks, especially those that have been under the cosh recently. Paul…

Read more »

Investing Articles

Are these the best stocks to buy on the FTSE right now?

With the UK stock market on the way to hitting new highs, this Fool is considering which are the best…

Read more »

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Can the Centrica dividend keep on growing?

Christopher Ruane considers some positive factors that might see continued growth in the Centrica dividend -- as well as some…

Read more »

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »