With the global markets suffering, many stocks are selling much lower what they should. Is there real book value behind a company, or are today’s bargains just tomorrow’s value traps?
Spotting value traps
A value trap is a stock that has dropped in value to appear like a great investment, but is actually a risky one. One example of a modern value trap might be General Motors, which sells much lower than its highs, but still reports huge losses and pension debt. A value trap stock might have lost much of its value, but is still no better of an investment at $20 per share than it was at $60 per share.
After disappointing earnings, a stock often tanks in price. This reaction is usually a knee-jerk, happening just minutes after the earnings release. More often than not, these stocks are sold with investors conducting minimal due diligence. Investors start selling before the reading into the actual earnings, merely following the crowd into a short position against a weak earner. This kind of position is very dangerous, and often rewarding to an investor with a long term investment horizon.
Stocks need a reason to move up in value. A low valuation compared to large asset holdings is not enough to get a stock out from the bargain bin. There would be no point buying a stock at $10 per share with a book value of $15 if the stock won’t move higher. There are many stocks like this today; they produce reasonable earnings but do not have the glamour and glory to move up in value.
Holding out for big funds
Many investors try to hunt through the bargain basement of $10 or under stocks. These are hard to bring up from their small value days, as many mutual funds and institutions disregard stocks with a low value. Buying and selling these stocks is risky for institutions because volume and the difference between bid and ask prices can make a profitable holding sell for less than its real price.
Low share price
Stocks below $10 usually have a hard time coming out from the pits. The investor who shops for these stocks will be at the peril of other investors who are die-hard in their holdings and do little in the way of trading. You might be caught holding these stocks indefinitely, as it will take a serious earnings report or a new valuation to grab the attention of institutional investors.
Buyouts might be the only option
The best option for undervalued companies usually comes in the form of a buyout or a share swap deal. Corporations with high cash reserves like to buy up these small, undervalued companies in an effort to reduce competition and boost asset holdings. This usually results in a stock for stock trade, where the investors in the company being bought out receive equal share value in the stock that is doing the purchasing.