Sensex and Nifty are at an all-time high, with the BSE Sensex surpassing the 72,000 mark and the Nifty 50 crossing 22,000.
As stock prices are soaring high, it is natural for any investor to look for lower-priced or undervalued stocks. However, if you do not analyse the ‘why’ behind the undervaluation and just go by the ‘how much’, you may fall into a value trap. With a little bit of effort and observation, you can avoid these traps and make wise investment decisions; let’s find out how.
What is a Value Trap?
If a stock seems undervalued based on financial metrics such as price-to-earnings ratio (P/E ratio), dividend yield, or price-to-book value ratio (P/B ratio) but does not reach its intrinsic value or even declines over time, it can be a value trap.
This is quite similar to the ‘steal deals’ you see on different online portals, but once you buy the product, most of the time, the quality does not match the details provided on the site, or even the reviews and ratings. While value investing is undoubtedly one of the best ways to generate wealth over time, not every undervalued stock is genuinely undervalued; it can be cheap as well.
What Causes a Value Trap?
Value traps can result from factors such as lack of research and the launch of new products and services, which help elevate the game of the company. Then it can be a cyclical stock, which is at its peak during the cycle, which in turn projects a higher P/E ratio but once the season is over, the P/E falls and so are the hopes of the investors.
For instance, an automobile stock seems undervalued based on its high P/E ratio during the wedding season or festive season. It may be due to a rise in its sales, which pushes the stock price upward, but the actual earnings of the company may not change in the long run; it can be only cyclical demand pushing the price up. So, there can be multiple reasons for a value trap, but how to avoid a value trap? – let’s see.
How to Identify and Avoid Value Traps?
To identify and avoid value traps, here are some factors you can keep your eyes on.
Peer comparison: The primary factor that can indicate a value trap is a stock continuously underperforming/ undervalued compared to its peers/ competitors. If a company has underperformed even when its top competitors performed well, the stock needs further research and analysis, and one should not just invest in it looking at its undervalued state according to P/E or P/B ratio.
For instance, if you look at the five-year return of RBL Bank, it has offered a negative 14.45% during the period; however, its PE ratio of 14.71 stands above the median PE ratio of 12.88 for the sector. On scrutiny, you can see it has contingent liabilities of Rs 73,405 crores, which is a huge concern for the investors.
(Data as of 22 February 2024)
Exponential dividend yield: A company paying dividends to its investors is a sign of growth and good performance. However, if the company is going over the top with its dividend payment, then there can be something fishy. An undervalued stock, with an exceptionally high dividend yield can indicate poor performance of the company, and it is trying to retain its investors by paying high dividends. In the long run, the company may not survive due to cash crunch, and poor management.
Lack of research and development: Another important value trap indicator can be a business, which invests less in its research and development. This market is ever-changing, and the preferences of consumers change over time, so, if a company is not investing for its future consumer, its business will eventually drop even though it is undervalued at present and seems a great investment opportunity but in reality, it can be a value trap.
For instance, Coffee Day, which has a PE ratio of 9.85, delivered a negative 25.85% CAGR in the past five years. The sales growth rate, which has dropped 24.8% in the last five years indicates a loss of customer base as in the FMCG sector, preferences change fast.
(Data as of 22 February 2024 )
Concentrated ownership: If the major portion of the ownership of any company lies with its internal members or institutional investors, leaving behind nominal ownership with retail investors, it can be dangerous for the latter. Even the price of the stock can be manipulated by the insiders to create a value trap. Therefore, before investing, you need to go through its ownership/ investors’ structure as well.
For instance, Yes Bank delivered a negative 35.11% return in the last five years even when its market capitalisation stands at Rs. 75,648 crores and a PE ratio of 73.9. Apart from poor sales growth of 2.29% and no dividend payments, the concentrated shareholding pattern is an issue here. Institutional Investors hold more than 60% of the stakes in the company.
(Data as of 22 February 2024)
Wrapping up
As they say, ‘All that glitters is not gold’; similarly, not every undervalued stock may be a genuine investment opportunity. So, just looking at the P/E or P/B ratio of any stock to identify whether it is lower than its fair value or not, may get you into a value trap. When the overall markets are surging high, if a stock is undervalued, it can be a great investment opportunity, but only if you look at it from every perspective.
That’s it for today. We hope you’ve found this article informative. Remember to spread the word among your friends. Until we meet again, stay curious!
*The companies mentioned in the article are for information purposes only. This is not investment advice.
*Disclaimer: Teji Mandi Disclaimer
