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Fireworks ignited one day early on Wall Street this year.
The market kicked off the second half of the year on a positive note, with the Dow reaching an all-time high on July 3.
Granted, July 3 is usually a solid day for stocks. Since 1928, the S&P has generated positive returns 73% of the time, according to Bespoke Investment Group.
But the overall momentum in the market is tough to ignore. And as the upward trajectory continues, it’s getting more difficult to find cheap stocks.
Be careful, though!
As investors get increasingly desperate to find a bargain, they tend to fall for “value traps.” That is, stocks that appear cheap on the surface — but are actually fundamentally unsound.
I asked senior analyst Martin Hutchinson to take a deeper dive into value traps. Check out his full analysis below to see how to avoid falling for them in the coming weeks.
Ahead of the tape,
Chief Investment Strategist, Wall Street Daily
Question: Martin, you’ve agreed to help us compile a library of the most important investment catalysts on Earth.
These are baseline concepts that every investor should know. And today we’ll be discussing value traps and how low stock prices can appear so attractive to investors.
Let’s jump right in, Martin. Why are beaten-down shares in some cases a trap?
Martin Hutchinson: Well, it’s interesting. Value traps are shares that appear to be cheap because the stock is trading at a low P/E multiple, price-to-book multiple or cash flow multiple. But then they stay cheap — or move cheaper — because of fundamental unsoundness, which is the general reason why something’s a value trap.
There are a number of reasons why cheap stocks can turn out to be value traps.
Firstly, the sector can be doomed because of new competition. Like retail now, which I don’t think is completely doomed but certainly has doom around it.
Second, earnings can be inflated because of temporary conditions. Like oil companies in 2013 (when oil was $100 a barrel).
A good example of this is a company called Thompson Creek, which I bought in 2011.
It was a molybdenum mine that had consistently good earnings and was then selling on five times multiple P/E ratio. It had just bought a new copper and gold mine.
However, molybdenum prices turned out to be in a bubble. Who knew? It fell below production cost. The copper and gold mine took 50% more than budgeted to build. The company loaded up with debt, closed the molybdenum mines and the copper and gold mine couldn’t pay the debt.
Eventually, I sold for a tenth of my buy price in 2016. That’s a very good example of a value trap.
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Then also the company may be too small to attract institutional interest or it may have no catalyst that makes stock prices rise.
Question: Now, Hutch, there’s a psychological component at play here for sure, particularly when we’re in a bull market.
The nature of investors is they just want to buy low, sell high. So they try to buy a stock that fits.
But you have to ask yourself… In the middle of a bull market if a stock is trading on the low end of things, something’s likely fundamentally wrong, right?
Martin Hutchinson: Something may well be fundamentally wrong but there are some sectors that just go out of fashion for some reason. It’s difficult to tell.
I distinguish between two different types of value traps. There are ones that are on the way to bankruptcy and ones that just sit there.
People talk about a company that just sits there being a value trap. And obviously when everything else goes up, to some extent it is.
But the ones that just sit there can be a very good investment if they pay a good dividend. After all, that’s what investment was all about until the 1950s. You didn’t look for capital gains; you looked for dividend. You’ve got to remember the other way around.
High-price stocks often fall without doing anything wrong. There’s nothing wrong with a cheap stock that stays cheap.
The real trap is where the business is unsound or earnings depend on a temporarily inflated price — such as oil in 2013 or molybdenum in 2010/2011.
The term “value trap” is often used by people trying to sell you growth stocks. They make value stocks seem more dangerous than they are.
You have to remember that fundamentally cheap is good. With the value trap concept, it’s useful to remember that there can be dangers. But there aren’t always dangers.
Question: But it’s a worthwhile endeavor to try to find good prices out there.
There may be actually some values in a bull market out there where stocks for some reason are lagging behind other stocks.
In other words, all stocks that are trading down aren’t value traps. There are some hidden gems out there. Am I correct on that?
Martin Hutchinson: Absolutely, and my belief is looking for those is likely to do you much better in the long run than chasing the ones that are going up all the time.
Question: Is it safe to say that you’re just basically flipping what you said about how to avoid a value trap? You’re basically just flipping that?
You’re looking for companies that are beaten down but are fundamentally sound companies, is that correct?
Martin Hutchinson: Yes, that’s correct but always remember the concept of a value trap. In other words, look for the snags before you buy.
Question: OK, so there are companies in this bull market that are trading way behind the market and lagging. So before you jump in those, make sure that you’re not jumping right into a value trap.
I’ll give you the final word, Hutch.
Martin Hutchinson: I think that’s absolutely right. The concept of value traps is useful to remember, that there’s danger out there even in cheap stocks.
Question: Thanks for your time today, Hutch.
Martin Hutchinson: Great to be with you.
Question: This is Wall Street Daily, signing off.
Senior Analyst, Wall Street Daily