Beware of Value Traps

The classic mantra of investing is “buy low, sell high.” Value investors, including great investors such as Warren Buffett, heed that, looking for undervalued stocks in which to invest. You’d do well to follow this strategy yourself, but beware of value traps.

A value trap is a stock that has fallen in price and appears to be undervalued — but it’s not. Here are some warning signs:

• Debt issues: If a company has taken on too much debt — perhaps in order to buy another company or just to keep operating — that’s a red flag. It will have repayment obligations that can hamstring it, and if it’s not generating enough cash to pay down its debt, it can spiral into deep trouble.

• Competitive issues: If the company is losing ground to competitors, which is reflected by a shrinking market share, it may be hard for it to maintain its value. Rivals may be offering higher quality or better prices.

• Cyclical issues: Many companies are in cyclical industries whose fortunes ebb and flow with the economic environment. During a recession, for example, fewer people will spend money on cars, refrigerators or travel, and companies in those businesses may temporarily slump. But if a cyclical company is slumping during an economic boom, that’s worrisome.

• Management issues: If management doesn’t seem to have a good strategy in place, or isn’t executing its strategy well, that doesn’t bode well for long-term success. If there has been a big change in leadership, that can be a wait-andsee situation, too.

• Dividend issues: If the company is paying a generous dividend but isn’t generating enough income to cover that obligation, or to increase its payout over time, that’s a concern.

If you spot a possible value trap, dig deeper into it. Or just steer clear of it and instead focus on solid, easyto-understand businesses, ones with strong track records and that seem well positioned for growth.