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Is that share a value trap?

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When learning about investing, some lessons are harder than others. Putting hard-earned money into what seems like a promising investment only to see it disappear is a painful experience even very experienced investors suffer.

That is one reason diversification is so important as a risk management strategy. One big risk investors face is what is known as a ‘value trap’. Here I explain what it is, and the value trap indicators to look out for.

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What a value trap is

We’ve all been tempted by value traps in life. The thing that’s to0 cheap to be true – a holiday, a second-hand car, a doer-upper flat. What looks like a bargain turns out to be anything but. The same applies to shares. A value trap is a share that looks surprisingly cheap, but actually is not cheap at all.

Imagine, for example, a company that is heavily reliant on one source of income, such as a medical patent or a particular client. Looking at their earnings for recent years, the shares look cheap. But if it turns out that the future earnings are greatly reduced — the patent expires, the client goes under — then the shares aren’t cheap at all.

That’s why it is important to look at a company’s likely future earnings, not just its past record. As well as earnings, I like to look at free cash flow – the money coming in the door. That is a better indication of whether a company is genuinely profitable.

Sectoral shifts can be value trap indicators

A change in a business marketplace can create value traps. For example, the high street is changing rapidly. I think retailers like B&M are adapting to this and can thrive. But a company like Card Factory faces not only a changing high street, but also shifts in consumer card sending patterns. A single digit price-to-earnings ratio is one potential indicator of a value trap – and Card Factory has that. Five years from now, we could be looking back at Card Factory’s share price today as a great bargain for a well-run business. But equally, we could be looking back wondering why people still believed in the investment case when card shops look like a declining business.

Other value trap indicators can include very high yields, a preference for unusual accounting metrics, and high net debt. But none of these is necessarily conclusive. Some companies that look like value traps are in fact great bargains. As the market has marked their chances lower, the share price has tumbled. So they can present a real bargain.

Just looking back at lows from last year, it’s incredible that some shares were as cheap as they were. Similarly, while Card Factory faces a challenging retail environment, it is a proven operator and has been able to adapt its offering, growing sales on its website for most of last year by 137%. Greeting card companies are in vogue, as the listing of Moonpig demonstrated. If Card Factory survives and thrives, today’s share price could be a bargain.

That’s why I find it worth investigating more about an apparent bargain. Some clear value trap indicators scare me off. But sometimes, a share can look like good value, not a value trap.

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christopherruane has no position in any of the shares mentioned. The Motley Fool UK has recommended B&M European Value and Card Factory. 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.

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