A value trap occurs because a once great stock gets into trouble that they cannot get out of. It is probably cheap because it has problems but people remember it doing great in the past and think that it is a good time to buy because it is cheap. The real problem occurs when it cannot recover from its problems.
I recently reviewed Empire Company Ltd (TSX-EMP.A, OTC-EMLAF). This is a company that some analysts are worried about being a value trap. They are in trouble with trying to integration of Safeway. It is not yet clear that they can resolve the problems with Safeway.
I know people are always saying to buy good companies when they are cheap. How do you tell if the company is a value trap or not? Well first find out why a good company is selling cheap. If the broad market is in a bear market and a good company is cheap, it is probably not anything that the company has done. If the sector that a company is in is in a bear market, again it is probably not anything the company has done.
When you should be careful is when a company is cheap because action taken or not taken by a company. The following are some possible questions to ask. Did the company do anything wrong? Can they recover? Have they got a feasible plan? When companies have been around for a long time, sometimes they need to reinvent the company to continue.
An example of a company that got into difficulties and then put together a clear plan to resolve their problems was TransCanada Corp (TSX-TRP, NYSE-TRP). The company got into difficulties in 1999 and cut their dividend and reorganized. In 5 years' time their dividend has surpass the dividend high of 1998 and the company was again doing well. I bought it in 2000 at a very good price and did very well. Nizar Amarsi in a Morningstar article gives examples of Value Traps in Torstar Corp (TSX-TS.B) and Atlantic Power Corp (TSX-APT, NYSE-AT).
The Investopedia has a definition on this term. This site of Investopedia also has an article on how to spot value traps. This article by Chuck Carnevale in Fast Graphs is rather long and contains good information. It is interesting that he criticizes the definition in Investopedia for focusing on stock price rather than the health of a company. There is an interesting article on this subject by Edward Chancellor at Institutional Investor.
On my other blog I wrote yesterday about TMX Group Ltd (TSX-X, OTC-TMXXF)... learn more. Tomorrow, I will write about Artis REIT (TSX-AX.UN, OTC-ARESF)... learn more on Friday, July 15, 2016 around 5 pm.
This blog is meant for educational purposes only, and is not to provide investment advice. Before making any investment decision, you should always do your own research or consult an investment professional. I do research for my own edification and I am willing to share. I write what I think and I may or may not be correct.
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