In value investing, one of the most important and difficult aspects of stock selection is determining whether you have found a real value investment or a value trap. The father of value investing, Benjamin Graham, spent a considerable amount of time trying to differentiate between true value investments and value traps.

What is a Real Value Investment?

The price of a real value investment is low because of temporary factors. Its price is a bargain because it trades below the real or intrinsic value.

Characteristics of a real value investment would be consistent and/or growing cash flow for shareholders, a business plan for products that have strategic advantages, and quality straightforward financial statements. In addition, the price must be low enough that it provides a margin of safety; therefore the purchase price you are willing to pay should be substantially less that its real worth.

What is a Value Trap?

The price of a value trap is low because of long term or more permanent factors. Its price appears to be a bargain but in fact is not selling at a price below its intrinsic value. This is usually because something is different, or is going to change, that negatively affects the earnings or cash flow of the company.

Have you ever bought a stock you thought was cheap and it just got cheaper and cheaper? That is a value trap. It appears to be a bargain compared to its previous price, but in reality something has changed and the lower price is discounting or warning of deterioration or change ahead.

One of the goals of every value investor is to avoid value traps. None of us want to buy a cheap stock and have it get cheaper. But even the best value investors sometimes get stuck.

Fortunately, we can take steps to maximize the probability of purchasing a real value investment:

7 Factors to Consider Whether Your Investment is a Value Trap

1. Earnings and Cash Flow

If a stock’s price is very cheap compared to past earnings this is a warning sign. Past earnings have little effect on the future price of an investment. The markets are looking forward to discount future cash flows. If an investment has fallen to the point where it is absurdly cheap compared to past earnings, that is a clue something is deeply wrong.

2. Business Plan

Beware of a business plan that is not understandable or is unprofitable. If a company is unable to make profits or has a plan that is complicated and hard to explain – avoid it.

Bypass companies whose business plan has been outdated by new technologies. If a product or service is outdated it doesn’t really matter how many other good attributes the company has; it will most likely fail. Technological obsolescence is a common misfortune of many business plans.

3. Management

Poor management can sink almost any company. If management is selling stock, giving guidance that is untrustworthy, or cutting the dividend; beware. These would be signs of a possible value trap.

Look for management that owns their company’s stock; insider buying is a positive sign. Quality management will give trustworthy guidance and demonstrate they have the knowledge to successfully guide the company.

4. Accounting

Producing complicated or fraudulent company accounting reports often means there is additional hidden problems. Any hint of fraud should eliminate an investment from consideration for purchase. This usually results in further declines in the stock or bond price.

Real value investments will have transparent financial reports and credibility with investors. Quality companies with sound management will demonstrate openness and honesty with their successes and failures.

5. Balance Sheet / Debt

The balance sheet may be more important than the income statement for sorting out value traps. High debt can cause problems with liquidity and solvency that can sink an otherwise good business plan. A highly leveraged company has less leeway for making mistakes or overcoming obstacles.

A strong balance sheet is the foundation of a quality company and provides a margin of safety. When a company faces adverse conditions a conservative capital structure gives them the financial flexibility to meet the challenges.

6. Strategic Advantages

A company that lacks strategic advantages to overcome tough competition or heavy regulations can lose their ability to compete. In todays cutthroat global markets a company must have sustainable competitive advantages. Before purchasing a cheap stock be sure the company has competitive advantages that will provide the cash flow and growth needed to raise the price of the stock.

Does the company have the ability to stay ahead because they are a market leader, have economies of scale, pricing power, differentiation of product, cost benefits, or have powerful brands. Without one or more competitive advantages the company may not be able to thrive.

7. Look Forward Instead of Backwards

A stock may look cheap when compared to its past earnings. But the market values companies on future earnings and growth of those earnings. What a company has earned in the past will have little to do with its value today.

Most financial sites quote P/E ratios based on past earnings. Looking forward means estimating future earnings and cash flows; then comparing those metrics, not past metrics, to the current price.

Value Trap or Real Value Investment?

I warned in the first sentence that it is difficult to determine the difference between a real value investment and a value trap. Even the best value investors buy value traps. Making mistakes is a part of investing risk.

The goal is to maximize your probability of purchasing a real value investment, and minimize buying value traps. Use these 7 factors to weed out potential value traps; then focus on the real value investments you might want to add to your portfolio.

Can you think of other factors that would differentiate between real value investments and value traps? Please share them with me!

Related Reading: Investment Analysis: High Probability Strategies