Value Traps: Bargain Hunters Beware!

Investors often fall prey to value traps when they go hunting for a bargain. These "bargain" stocks may appear promising, but at the end of the day they are a big letdown for investors and they don't go anywhere.

In this article, we'll show you how to hunt down a valuable stock without getting stuck in a value trap.

Companies that have been trading at low multiples of earnings, cash flow or book value for an extended period of time are sometimes doing so for good reason—because they have little promise—and possibly no future.

A terrific example of this type of value trap was found in Rag Shops Inc., a now-defunct company that sold fabric and craft supplies. For years that company traded under or at book value and looked cheap by several measures. Its stock hardly ever budged, causing investor confusion.

The reasons for this stock deadlock were:

1. The company had difficulty generating meaningful and consistent profits and was unlikely to generate institutional or substantial retail interest.
2. Management was reluctant to get out on the road and tell the company's story to retail and institutional investors.
3. Competition from other craft outlets, including Michael's and A.C. Moore, was extremely stiff, and the company was unable to differentiate itself.

Rag Shops ultimately filed for bankruptcy, and investors that were lured in by its once low price-to-book multiple ended up with nothing more than a tax loss. (See also: Value By the Book, Digging Into Book Value and Fundamental Analysis: A Brief Introduction to Valuation.)

Companies and stocks need catalysts in order to advance. If a company doesn't have new products on the horizon or expect to show earnings growth or momentum of some kind, consider avoiding it.

A company's history should never be overlooked, and it should be compared to what the company's current financial statements look like. If the company cannot improve upon its position operationally, it may have trouble competing with companies that can. Ultimately, the company will probably also have trouble garnering interest from the investment community.

Many seasoned investors and sell-side analysts wait until a catalyst gets ready to hit the market and buy or recommend the stock then. Once the catalysts evaporate or transpire they will jettison the stock.

Some companies, like Berkshire Hathaway, have Class A shares and Class B shares. The difference between the two classes of stock depends on the situation. Class B shares may contain super (or, advanced) voting rights. For example, one vote of Class B shares might be the equivalent of the votes of five Class A shares. Class B shares may also contain a special dividend or other special right not granted to the average common shareholder.

The average investor should be wary of investing in a company with two classes of stock. The reason for this is that the owners of the Class B shares generally are insiders or large investors and the company tends to focus on keeping those investors happy rather than paying attention to the common stockholder. (See also: Delving Into Insider Investments.)

There are many parameters that a company or stock must meet in order for the average institution to take a position in it. Many funds won't take a position in a company unless its stock trades for $10 a share or more. Fund managers and analysts may also be forbidden from getting involved in companies whose annual sales total less than $1 billion or that are unprofitable. Of course, there are usually other prerequisites and parameters as well (for institutional participation) and they usually revolve around a company's float.

Companies with a small float or with few shares that trade in the public domain are unlikely to garner institutional attention because those investors will have trouble acquiring and ultimately disposing of large quantities of stock. When institutions cannot participate in a stock, the shares tend to languish; by extension, they may become a "value trap."

It is usually a positive sign when insiders at a company own large chunks of their company's stock, as it usually gives those insiders ample incentive to find ways to enhance shareholder value.

Many institutions and entities that can move stocks (i.e., mutual funds and hedge funds) will usually not get involved in a company if it has a high percentage of insider ownership. If insiders own a high percentage of the shares, the investing institution may not be able to influence the board of directors or to have a say on corporate governance issues. This lack of institutional interest could cause a stock to seriously languish.

Although a company may seem like an attractive investment candidate because of a low multiple, unless it has catalysts on the horizon, interested institutional investors, insider incentives and ample floats, the stock could lead you into a value trap.