What are "value traps" when investing?

This content is for information purposes only and should not be taken as financial advice. Every effort has been made to ensure the information is correct and up-to-date at the time of writing. For personalised and regulated advice regarding your situation, please consult an independent financial adviser here at Castlegate in Grantham, Lincolnshire or other local offices.

Psychologically, it feels great when we buy a “bargain” - especially when the item is a rare, expensive product that we really want (e.g. a 1st edition book). Similarly, investors can feel elated when they buy company shares - or funds - which appear to be selling for less than their “intrinsic” value. However, sometimes shares like these are priced low for a good reason, leading many investors to fall into a “value trap”.

In this article, our financial planners at Castlegate, here in Grantham, explain what “value traps” are and show how investors can approach value investing. We hope you find this content helpful. If you want to discuss your own financial plan with us, please get in touch to arrange a no-obligation financial consultation, at our expense:

01476 855 585
info@casfin.co.uk

What are “value traps”?

Have you ever bought something for less than you think it is worth? Did you expect to sell later for a profit, but no one was interested? If so, then you likely fell into a value trap. Perhaps the item was selling at a discount because the vendor anticipated that the market would no longer see value in it (e.g. due to technological obsolescence).

When investing in shares and funds, this involves “buying” them for a price set by the wider market. This price may be “high” or “low” from the buyer’s perspective, depending on their valuation process as well as metrics such as price-to-earnings (P/E). Sometimes, the investor may come across a stock or fund which appears to be trading at a low price.

This might be because the wider market is overlooking the potential of the investment. However, it could be that the market perceives problems in the investment not noticed - or discarded - by the individual investor. This might be financial instability within the company in question and/or limited growth potential. In which case, investing in it could lead to few - even negative - returns.

How do I avoid value traps?

If you plan to invest in equities (the stock market), then valuation will likely play a role in how you choose investments for your portfolio. A good starting point is to sit down with your financial planner and use a set of agreed criteria to narrow down on a shortlist of funds (for possible inclusion in your portfolio). Some ideas for criteria might include:

• Fund/company history. Whilst past performance is not a guarantee of future results, previous returns can demonstrate a “proof of concept” to investors. If there is a strong track record already in place, it can mitigate risk and give confidence of future growth.
• Fundamentals. Do the companies within a given fund show strong balance sheets, cash flow statements and income statements? If a fund comprises many stocks which carry high levels of long-term debt, tight margins and low returns on invested capital (ROIC), then this is likely a red flag to investors.
• Sector and market diversification. Making sure you include funds in your portfolio that cover a wide range of industries, company types (e.g., large and small cap) and global markets can help limit the risks posed by a single investment - including value traps.
• Headwinds and tailwinds. Whilst nobody can predict the future, your financial planner can help shed light on wider factors in the economy, society and political landscape which could affect how certain companies and industries perform in the years ahead. Energy is an interesting example. With increasing global pressure to tackle the climate crisis, oil & gas companies are likely to face increasing demand to lower their carbon footprint. Former head of the Bank of England Mark Carney, for instance, has warned that pension funds could be hit if they do not limit exposure to fossil fuel investments which do not adapt to climate change.

Implications for investment strategy

What constitutes a “value trap” is not universally agreed. Some investors will regard a certain investment as a bargain, whilst others may see it as worthless. Here, it is important to note that much of the discussion around value traps concerns how to invest in individual stocks. In our experience as financial planners, most retail investors will do better by selecting an appropriate range of funds which fit their investment goals and strategy.

Indeed, multiple studies suggest it is exceedingly difficult for most investors (even experienced ones) to match a market index over the long term - let alone beat it. The time, discipline and investment insight required is simply too high a demand for the majority of people who wish to invest successfully and get on with their lives. At Castlegate, we understand this and so help individuals craft a strong portfolio which does not require needless hard work.

Whilst you should be wary of dangers such as value traps when investing in the stock market, this becomes less of a concern when you have a diversified portfolio and well-grounded, long term strategy which is built on strong investment principles. We can help you achieve that.

Conclusion & invitation

If you are interested in discussing your own financial plan or investment strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:

01476 855 585
info@casfin.co.uk