Value traps: definition, causes and ways to avoid them

Value traps: definition, causes and ways to avoid themAs the regular readers of this blog already know, the value investing consists of buying shares of companies that are listed at a price below their intrinsic value and that they offer a safety margin reasonable. The main task that value investors have is to analyze listed companies in search of companies that meet the aforementioned characteristics. The problem is that, sometimes, there are companies that seem undervalued, but they are not, quite the opposite. In this article we will see what value traps are, the causes of their existence and some recommendations to avoid them.

What is a value trap?

A value trap is a company that appears to be trading below its intrinsic value but is, for some reason, not undervalued, but overvalued.

For example, they usually quote at a FOR of a figure or being in a high growth sector. However, they always have some hidden or underestimated or overlooked risk factor that makes their real intrinsic value much lower than the intrinsic value we have calculated.

Why do we fall into value traps?

The reason we fall into value traps is always the same, an error in the valuation of the company. This error is not always easy to detect, and even in some cases it is almost impossible, as in the rare but notorious cases of accounting fraud.

Many value traps are the consequence of errors in the perception of the problems that a company is going through or will go through. All companies, sooner or later, go through a series of complications. However, they are not all the same. We can distinguish two types of problems:

  • Short-term problems: They are those that are due to specific circumstances. They are passengers, so the company ends up recovering from them after a while.
  • Structural problems: These are more serious problems that affect the foundations of the company and its business model. It is very difficult to get out of these kinds of problems.

In most cases, value traps are related to structural problems, which are often undervalued or overlooked when investing in the company.

There may also be other causes, such as accounting fraud, financial mismanagement, or increased competition. In another article, I will explain the types of value traps in more depth with examples of each type.

How can we avoid falling into value traps?

My first recommendation, especially to novice investors, is that you don't neglect diversification. In this way, even if you fall into a value trap, its relative damage will be much less if your portfolio is made up of 20 stocks than if it is made up of 5.

Another of my recommendations to avoid falling into value traps is to invest in stable companies with a long history. It is much easier to be highly successful in the short term than to maintain moderate success in the long term.

Unfortunately, there is no foolproof way to never fall for value traps or make mistakes. All value investors, sooner or later, end up falling into value traps. I, the first. Even value investing legends like Bestinver year after year they fall into some value trap, and they have always known how to admit their mistakes and learn from them. These errors have not prevented Bestinver's long-term profitability from remaining exceptional.

We have to learn to deal with value traps and all investment mistakes in general as one more part of the investment learning process. More important than not falling into value traps is learning from mistakes. In this way, we will end up complying with the 2 most important stock investment rules according to Warren Buffet:

Rule # 1: Don't lose money.

Rule # 2: Never forget rule # 1.