Every investor loves to find an undervalued stock. In fact, the value investing strategy has been touted by some of the greatest investors of all time, including Warren Buffett. 

Value investments can provide the rare combination of low risk and high returns, but there are some pitfalls to watch out for in your search for undervalued stocks. 

Value traps are stocks that can appear undervalued, but ultimately end up disappointing investors. Here’s more on what value traps are and how investors can avoid them.

What is a value trap?

A value trap is a stock that appears undervalued but actually isn’t. 

Value investors look to buy stocks that are trading below their intrinsic value, which values a company based on the cash it will produce for its shareholders over its remaining life. Some metrics, such as the price-to-earnings (P/E) ratio, may provide clues about whether a stock is undervalued, with value investors looking to buy shares when multiples are low.

But buying a stock at a low multiple of current or recent earnings isn’t a guarantee of investment success. What matters for a stock is its future earnings and cash flows, which can sometimes be quite different from a company’s historical results. 

Value traps may see their stocks decline or be relatively flat for an extended period of time as investors reassess the company’s fundamental outlook.

Value trap example

IBM is one of the most storied tech companies in the world, and in 2011, the stock appeared undervalued. IBM shares traded for around $160 for much of the year, and the company would ultimately earn $13.44 in diluted earnings per share, representing an attractive P/E multiple of about 12.

Buffett revealed in November 2011 he’d purchased nearly $11 billion of IBM stock for Berkshire Hathaway, the conglomerate he’s run since the 1960s. In his 2011 letter to shareholders, Buffett praised IBM’s management.

“Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders,” Buffett wrote. “The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.”

But IBM shares languished for the next decade, as the company struggled to grow revenue and margins were pressured lower. Berkshire exited its IBM stake by early 2018 as it added to its position in Apple, which eventually became Berkshire’s largest holding. 

How to avoid value traps

Value traps are difficult to avoid, and there’s no foolproof way to ensure you never end up in one. The key thing to remember is that when you’re investing in a stock, you’re investing in a business, and your result depends on the success of that underlying business.

When you find a stock that’s trading at a low multiple of earnings or another fundamental measure, ask yourself if anything has changed within the business that warrants the new lower multiple. Some key questions to ask include:

• Is growth going to be lower in the future than it’s been in the past?
• Does the business face margin pressure?
• Is there a new competitor that’s taking market share from the business?
• Does the industry itself face a threat that has made the businesses in it worse off?

If you’re going to invest in individual stocks, you need to be able to analyze businesses. Thinking critically about their past and future can help you avoid value traps when you’re investing. If you do find yourself invested in a value trap, it’s best to realize it quickly and sell the stock as soon as you can.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.