What is an investment value trap (and how to avoid them)?

By Nicole Webb 26 February 2020 2 min read

When investing in shares, one of the trickiest things to know is if a share you are holding is on its way up or down.

Undervalued company's shares can be cheap and represent good value. Investors want to buy shares in these companies because its share price is expected to rise.

On the flipside, the company could look like it's good value because it’s on its way down and is bottoming out.

But how can you tell if a company is on its way up or down?

When is an investment undervalued?

An undervalued stock trades at a price below its intrinsic value.

Key metrics used to evaluate whether a company or share is undervalued are:

  • Price to earnings ratio (the p/e ratio is the price an investor pays for $1 of a company’s earnings or profit);
  • Growth potential (for example, is the sector or industry expected to benefit from any regulatory change, demographic shifts or consumer behaviour?); and
  • Balance sheet health (the state of its assets, liabilities and equity).

Or is it a dud?

One of the tell-tale signs of whether a share is bottoming out is to look at the overall sector’s performance.

For instance, if you are holding Apple and its share price has significantly decreased, you can assess the broader technology sector to see if it’s in lock step with the sector or whether its performance is out of cycle.

If it’s out of sync with the sector, it’s worth considering if the share price could be continuing to trend further downward.

Sometimes companies can look appealing but aren’t. They’re value traps.

A value trap is a company whose trading multiples make it look undervalued, but its operations repeatedly underperform, so it could be on the cusp of an earnings downgrade.

Avoiding dud investments

There are investment choices and investment strategies that you can use to help ensure that you are not at the mercy of trying to pick stocks yourself.

For instance, managed funds are one such option, which involves pooling your money with other investors into a fund.

There are a number of benefits to managed funds including professional investment management, diversification, convenience and access to a broad range of investment options.

Dollar-cost averaging is an available investment strategy that can also help minimise the risk of adverse share selection.

It works like this. You invest a set amount over a period of time, so you can benefit from changes in investment prices - that is, you end up buying more units when they’re cheaper and less units when they're more expensive. And this means you average out the cost of investing.

Why do people invest this way? Because timing the market is near impossible.

Investors who use this approach buy more shares, or units in a managed fund, when prices are lower and fewer when prices are higher.  

The driving attribute of dollar-cost averaging is around having a disciplined, non-emotional approach to investing that is free from market sentiment.

If you’re just starting your investment journey, there are a range of choices to ponder.

While you may not always be able to pick the winners, sound research and a cool head can certainly help.

You may also consider how seeking professional support such as help from a financial adviser can strengthen your investment experience and portfolio.

What is an investment value trap (and how to avoid them)?