Don't get caught out by value traps!

One of the most successful investing methods is value investing. Among proponents of this style is the world's most famous and most successful investor, Warren Buffett. He has become one of the world's richest men simply through buying high quality stocks at fair prices. And while emulating his style is a logical step for long term investors to take, value traps must be avoided or else your portfolio performance could be a huge disappointment.

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Of course, a value trap is easy to identify after the event. It is fairly straightforward to look at the share price fall of a company and say that it was obvious. Indeed, as Warren Buffett famously said, investing is always clearer through the rear-view mirror than through the windshield. However, value traps need to be identified and avoided, since they can cause severe losses over a prolonged period.

Essentially a value trap can occur where a company's valuation is appealing. For example, it may have a low price-to-earnings (P/E) ratio, or a low price-to-book (P/B) ratio. Therefore, value investors may decide that due to its upward rerating potential, it is worth buying. After all, the company may have performed well in the past, or the global economy may be forecast to grow. Both of these events could bolster the valuation of the company in question.

However, the reality is that many companies are cheap for a reason. It is extremely rare to find a company which is financially sound, is recording strong profit growth and offers a well-diversified business model trading on a low P/E or P/B ratio. As such, it is crucial to be somewhat cynical regarding cheap stocks and ascertain exactly what the reason is for such a low valuation.

In this sense, there are potentially two categories of problems which a company may face. The first is temporary and may include the loss of a major customer, a profit warning or some other factor which is fixable. Such companies should have huge appeal to value investors, since the low valuation on offer is unlikely to last in the long run. A new management team, new customer wins or even an improved industry and/or macroeconomic outlook could act as a positive catalyst and help to turn the company's performance around.

However, the second category of problems is permanent. This could include obsolete products due to technological change, brand damage or severe financial challenges such as sky-high debt and poor cash flow. In such a scenario, it will be incredibly difficult (if not impossible) for a new management team to rectify such problems and turn the company's performance around. As such, it is more likely that the company in question will record further falls in its share price, rather than an upward rerating.

Although buying cheap stocks is risky, it can prove to be highly profitable. However, there is more to value investing than merely seeking out cheap stocks. A company's management team, financial standing and forecasts must also be factored into the buying decision. As Warren Buffett said, it's best to buy a great company at a fair price than a fair company at a great price.

Avoiding value traps could help you to become a millionaire

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