A value trap is a stock that appears to be trading at an attractive price, luring in unsuspecting investors. But instead of being cheap, it turns out to be a losing company or investment. The stock price will be trending downward, leading to capital losses for investors who purchased it by thinking it was a good value. This came up recently when a casual investor I know said he was considering buying Philip Morris because its current dividend yield is a very attractive 7.8%. Plus, analysts are projecting this year’s and next year’s earnings to be higher. I explained that, in my opinion, this is exactly what a value trap looks like.
When a stock has been trading within a certain range for metrics such as:
- Stock price
- Price/earnings ratio
- Price/sales ratio
- Book value
- Dividend yield (the Siren song for retirees and beginning investors)
- Etc.
And when the stock price/metric falls below that range, many investors think, “Hey, it’s cheap now, I better jump on this bargain price before it disappears!” What these investors are failing to see is that there may be a material reason, something fundamental to the company that is creating a dim future for the business. It appears cheap only because the company may be at the beginning of a slow downward contraction. These material reasons can include:
- This industry is being replaced, disrupted, or slowly disappearing
- This company is simply unable to grow revenue or find positive investments
- This company is on an unsustainable path of new debt or stock buybacks
- The company has poor accounting or ignores capital asset and restructuring charges
- The company has flat or dropping revenue but earnings are increasing only from cost cutting – a tactic which cannot last forever
- The company makes a large acquisition for its size – and is starting to not go well
- This closed-end fund with a high payout yield is actually returning capital, lowering its net-asset value, and has an unsustainable business model. So it will dilute your equity position, reduce the dividend, or worse – all of which will create capital losses as the price drops.
There are many classic examples of large and successful companies that became value traps to any investor that bought them on their slow path to zero: Eastern Airlines, Eastman Kodak, K-Mart, Blockbuster Video, General Motors, Toys R Us, Compaq Computer, Zenith Electronics, Radio Shack, and many more. In the case of Philip Morris, it has several red flags for being a value trap: revenues are not increasing; smoking is becoming more unacceptable around the world; and their JUUL investment into vaping is rapidly deteriorating as legislatures are banning its sale. The stock is priced high for big growth and if that doesn’t arrive, sooner or later, the stock will be re-priced lower. Perhaps Philip Morris can re-invent itself, as so many successful companies have. But until then, in my opinion, it is a potential investment value trap that I would avoid.