Posted on November 13, 2014 by Evan 0 Comments

As a self proclaimed value dividend investor I tend to read related articles, posts and books on the subject and I always see the term value trap but I never actually looked it up.  Upon reading a little bit of the term, it feels like I am inevitably going to fall into one day, but I am not entirely convinced it matters all that much.

What is a Value Trap?

Investopedia provides us with a pretty good definition to start with,

A stock that appears to be cheap because the stock has been trading at low multiples of earnings, cash flow or book value for an extended time period. Stock traps attract investors who are looking for a bargain because these stocks are inexpensive. The trap springs when investors buy into the company at low prices and the stock never improves. Trading that occurs at low multiples of earnings, cash flow or book value for long periods of time might indicate that the company or the entire sector is in trouble, and that stock prices may not move higher. (emphasis is mine).

The Motely fool has an expanded definition that provides a little bit more information.

A value trap masquerades as a value stock because its stock price has been beaten down. However, unlike a true value stock, a value traps price is low for a good reason. Investors who buy solely on stock price are likely to be caught by value traps, because it takes investigation into the fundamentals of a company and its management to determine whether a stock is a value or a value trap. Because investors buy value stocks on the assumption that they will return to their intrinsic values, investors who mistakenly buy value traps risk losing the price appreciation they were anticipating.

I am not entirely sure what never means for Investopeida.  Does it mean within a year? a decade? a generation?  My holding period theoretically could be forever which means that if it is an value trap for a number of years and then eventually it explodes then it doesnt matter.  It feels like a discussion between value and stock price diverging, and if that is the case then I follow Buffetts advice when he says to ignore the price.

Am I Destined to Fall into a Value Trap?

Every single month for the past 2 or so years, I have provided guidelines as to what I am looking for in a particular equity:

1. The company has paid increasing dividends for at least 20 years – 154 entries this month!
2. The stock has to have a Price to Earning that is lower than their industry average. The Price to Earnings Ratio has to below 20 regardless of industry average.

3. The Operating Margin has to be in line with the particular stock’s industry average. I want companies that are profitable as compared to their peers.
4. Price to Book – Should be below 4, but if it isn’t it must be in line with industry average (or lower).
5. Dividend Yield Moving target but always above 2.2%.  This changes whenever I update the list depending how many stocks I have left after the first 4 steps.
6. Dividend Payout Ratio  — It took me a long time to add this to my screen but basically I weed out any companies paying over 60% to shareholders.  Couple reasons.  The main one would be sustainability, but also, I do want growth in a company and if all dollars are going out it is likely to hurt the company in the long run.

I then purposefully look for dips in the particular equity insofar as I eyeball the 52 week numbers.  My thought process? is that I can lock up a few percentage gains if the thing just gets back to where it may have been at some point in the last year.  So, I am buying cheap stocks when they dropsounds like I am inevitably going to one day fall into a value trap, right?

The next question for me is then does it matter if I plan on holding a company for years? a decade? until my son who is almost 4 is getting married?

An Example of What Could Have Been a Value Trap

Full disclosure: I handpicked this example after looking at a few of my positions.   I think it provides an example of what could have been someone bailing on a good business if they werent patient.

But I wasnt looking for short term trade so it didnt bother me.  I was holding a great company that was buying back shares. and increasing its dividend.

2012 to 2014 WAG Chart

If someone had a year horizon they might have felt like they were in a trap, right? I mean it didnt even beat the market in 2012.  However, as you can see from the above chart it destroyed it in 2013, and then compounding more into 2014.  I had sold some of my shares at $70 when it was grossly overvalued (although maybe I should have kept my head in the sand longer as it has come back after that initial drop to $60.

In conclusion, I dont think I have been around long enough to actually see a value trap in hindsight I couldnt find any great examples when googling the concept either.

Does anyone have any experience with value traps?