Symptoms of a Value Trap.

1. Investors falsely believe that names like Dell or eBay (Nasdaq: EBAY ) will
see their relative valuations return to their headier days. They wont.

Why? Captain Obvious would say that growth has slowed, technology
evolved, and competition emerged. But all that misses the real reason.
Instead of returning incremental profits to shareholders via dividends, such
companies wreck shareholder value by chasing growth through
overexpansion and high-profile acquisitions. Oh, and the ill-timed share
repurchases that exist primarily to juice per-share earnings and help sop up
all that stock option-driven dilution.
2. Cyclical
savvy investors know that cyclical companies profits mean-revert, which is
why cyclical stocks P/E multiples stay low during booms and high during
busts.

In other words, you should be looking at cyclical stocks as their P/Es expand,
not shrink.

3. The small-cap Methuselah

The six-year small-cap bull run that came crashing to a halt last year was a
painful reminder of a little-known value trap: the Small-Cap Methuselah.

Century-old small-caps youd never heard of were wrapping up five-year runs

of 20% annualized earnings growth. Analysts went gaga, extrapolating those
growth rates forward like the party would never end. Valuations followed suit.
Gaga analyst, meet mean-reversion
4. The too-high yielder
A company usually has a high yield (think above 7%) for one of three
reasons:

It has limited growth potential, so managers return as much cash as they can
to shareholders (think regional telecoms).

The company is in a clear state of decline and investors expect a dividend cut
(think newspapers).
The company is in a tax-advantaged structure that doesnt allow it to retain
much capital (think REITs, MLPs, or BDCs).

5. Dont lean on inflated or unadjusted book values.

Timothy Fidler of Ariel Focus suggests that there are two main types of value
traps:

Earnings-driven value trap - This is where the mirage of a low price/earnings

valuation vanishes as EPS evaporates over time - every time you think it
looks "cheap" again, earnings fall further. This process is usually persistent
and can last for years. More often than not, the misguided investment thesis
is some variation of "They used to earn X, so if they could just get back to
something near X, the stock would work well".
Asset-based value trap - Also known as "cigar-butts", these types of stocks
look exceptionally cheap in terms of asset valuation (e.g. the price/book ratio
relative to current profitability). In some cases, the trap is simply that the
reversion to the mean of unsustainably high profitability. However, Fidler
suggest that the real danger comes from companies with opaque or illdefined risks where the flawed investment thesis is "I know the risk is there,
but I think it is already in the price or over-discounted".
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Top 10 Signs that Your Stock May be a Value Trap

So here's a list of 10 tell-tale questions to ask to help figure out whether your
beloved investment may in fact be a steel trap - this list is inspired by the
excellent presentation given by James Chanos of Kynikos Associates at last
year's Value Investing Congress.

In no particular order, these tell-tale signs are:

1. Is the sector in long-term secular decline?

A company may simply be serving a market that no longer exists in the way it
used to. No matter how good the company, it will need a fair wind behind it
eventually and and if the sector itself is dying, it's likely to be a huge battle to
realise value. From a demand perspective, it's important to distinguish
between cyclical and secular declines. In the former case, short-term demand
will rebound with an improved economy. In the latter case, demand is in longterm decline (e.g. due to societal and demographic changes), which means
that the remaining players are left to fight for a share of an ever-decreasing
pie. This is the trap that Warren Buffett faced at Berkshire Hathaway, which
was a failing textiles business that he was unable to turn around before he
switched the focus completely into insurance.

2. Is the risk of technological obsolescence high?

Technological progress can radically reshape an industry and its product lines
- this can have a major impact on the life cycle and profitability of a firm (e.g.
the impact of the Internet on both newspapers and retailers). Chanos argues
that this has killed value investors more than anything in the past 10-20
years. One might assume that a stock is cheap enough to compensate for
decreasing cash flow but, sometimes, cash flows hits a tipping point and
drops off faster than you expect. A example given was Blockbuster which
apparently saw free-cash-flow go from $2bn to $500m in just 18 months!
Having said all that, the cycle of creative destruction can be unpredictable the US steel industry was given up for dead in the 1980s but was
reinvigorated by the invention of lightweight mini-mills.

3.

Is the companys business model fundamentally flawed?

Sometimes, a company may simply be serving a market that no longer exists,

or at a price-point that is no longer relevant, given competition and/or new
substitutes for the product. An example here might be K-Mart which looked
extremely cheap in the late 1990s vs. say Walmart but the lack of a
competitive business model meant that the company's earnings continued to
plummet. Because of leverage (see next point!), Kmart filed for bankruptcy in
2002. Alternatively, maybe it was just a dumb idea in the first place, or a
good idea badly-executed. While Tesco have shown that online grocery
deliveries can work, WebVan burnt through $375 million in the dotcom era

through investors overlooking extremely thin margins, unreliable delivery

times, and a lack of customer demand.

4.

Is there excessive debt on the books?

More often than not, financial leverage magnifies the pain of a value trap.
Limited or no financial leverage gives firms access to the the most precious
commodity of all - time! A company with no debt is unlikely to go under,
barring a major catastrophe (e.g. a massive legal settlement against it). On
the other hand, excessive leverage can destroy even a great company. For a
good margin of safety, the debt to equity ratio should be as low as possible
(and certainly below 1), and interest cover should be comfortable.
Conservative financing is one of the key criterion discussed as part of the
Buffetology screen.

5. Is the accounting flawed or overly aggressive?

It's best to stay away from companies where aggressive or dubious
accounting is employed. Chanos argues that you should be triply careful
whenever management uses some metric that they define, rather than
conventional metrics (Cable TV, Eastman Kodak, Blockbuster, and Tyco have
been examples of this in the past). If a company is only cheap on
management's metrics, such as EBITDA while ignoring restructuring charges,
this means very little.

Likewise, it's probably best to avoid with a wide berth stocks that have
dropped in price due to to corporate fraud. Some investors bought Parmalats
bonds in the summer of 2003 on the basis that they were cheap for a
company with a strong cash position and balance sheet only to find that the
Italian dairy group collapsed later that year with 14bn ($18.5bn) of debts.
Published financial statements always have to be taken with a grain of salt
and, wherever fraud is involved, the figures used to determine value are
probably meaningless. Montier's C-Score and the Beneish M-Score may both
help to flag issues here.

6.

Are there excessive earnings-estimate revisions?

Analysts are quite lenient and usually revise their estimates downward before
earning releases to allow companies to beat their estimates. Occasional

missed earning estimates can provide an opportunity to buy on the dip, but a
pattern of missing earning estimates may mean that management are
struggling to forecast properly, with a knock-on effect for the analysts, and/or
that management doesnt understand or are not willing to fix problems.

7.

Is competition escalating?

Be careful of companies facing increasingly stiff competition. Is there a

tendency for the industry to compete on price to squeeze margins? If there
are limited barriers to entry and a company is unable to differentiate itself,
then it's possible that the market structure has simply moved against it - it
may never recover the glory years of the past. One way to test this is to
compare the historic profit margin trend ove the last 10 years. If the profit
margins are decreasing, this may suggests the company is unable to pass
increasing costs onto its customers due to increased price competition.

8. Is the product a consumer fad?

Another sign of a possible value trap is a product that is subject to consumer
fashion or whims. Evolving consumer tastes and demand may mean that the
market for the product is just a short-term phenomenon. An example of this is
arguably Hot Tuna - as Growth Company Investor has noted:

Special Offer: Invest like Buffett, Slater and Greenblatt. Click here for details

"the surfwear fashion concept has for some years become increasingly out of
fashion since the late nineties... with Hot Tuna reporting losses every year
since 2006".

9. Are there any worrying corporate governance noises?

It's worth checking for any history or noise that suggests minority
shareholders might be getting a raw deal. In general, while there are notable
exceptions (e.g. Berkshire Hathaway), investors should probably be wary of
companies with a second class of stock with super-voting rights. The risk here
is that that the company will focus on keeping insiders happy at the expense
of common shareholders. A related flag is a very limited float or tightly held

company - while insider ownership can mean that incentives are aligned, it
may also act as a deterrent for institutional shareholder participation (since
they will find it difficult to trade in large quantities of stock).

10. Has the business grown by acquisition?

Chanos argues that growth by acquisition is a major sign of a value trap. In
particular, rollups of low growth, low P/E businesses with expensive high P/E
stock should be seen as a red flag. Be careful when you see big write-downs
because, while management is claiming to be conservative, they are likely to
be banking some earnings. Chanos gave the example of Tyco - in its last year
of business, it apparently bought $20 billion worth of businesses, and put $21
billion of goodwill on its books!

And you still need a catalyst...

Even if the investment doesn't suffer from any of these risks, the investment
may still end up being a dreary and difficult one, if there's no near-term
catalyst for the crystallisation of value. Via Expecting Value, we came across
a useful catalyst definition by value blogger, Wexboy as:

"any kind of transaction/fact/event/etc., actual or potential, that offers the

opportunity for a full/partial realization of value in a stock, within a
(reasonably) accelerated timescale".

Many seasoned investors and sell-side analysts wait until a catalyst gets
ready to hit the market and buy or recommend the stock then. In the absence
of any obvious catalyst, time will probably do the trick eventually but, in the
long run, we are all dead. And, as Wexboy notes, an extended wait for value
to be crystallised can have a dramatic effect on your returns:

Some examples of possible catalysts include: i) fresh management with new

direction, ii) a change in strategy of existing management (e.g. new product
strategy, business reorganisation or cost reductions), iii) a disposal or
purchase of a meaningful asset, iv) a recapitalisation of the business, v) a
takeover bid, or vi) activist shareholders who may put pressure on
management to act. - See more at: http://www.stockopedia.com/content/10worrying-signs-that-your-stock-may-be-a-value-trap-

63930/#sthash.Pcctwn54.dpuf

- See more at: http://www.stockopedia.com/content/10-worrying-signs-thatyour-stock-may-be-a-value-trap-63930/#sthash.Pcctwn54.dpuf