The term “value trap” refers to a stock that has a low valuation in terms of classic fundamental metrics such as the price-to-earnings (p/e) ratio, pays a high dividend, yet is a poor investment that underperforms the market and is “dead money.”

To understand value traps, investors should consider the old saying, “You get what you pay for.” Though my mother always taught me to be frugal as a kid, she also emphasized that I should not be cheap. For example, if you buy nice clothing made from better material, you will take care of it, enjoy it more, and it will last longer. The same applies to the stock market because, often, cheaper is not better.

 

What are the Signs of a Value Trap?

To understand value traps, I will break down some classic signs cover some examples to prove my points.

 

1. “Cheap” Valuation

As I mentioned, value traps are cheap based on traditional metrics, such as price-to-earnings, price-to-sales, or price-to-book ratios. However, investors need to understand that a low valuation is not bearish but it is not necessarily bullish either. Like most investing metrics, context matters.

For example, telecom giant AT&T (T) has a valuation of 7.75, which is roughly a third of the S&P 500 Index’s 24.4 P/E.

Image Source: Zacks Investment Research

Despite the low p/e (which has been lower than the S&P 500 for years), AT&T is down 25%, while the S&P 500 is up 25% over the past five years.

 

2. Stagnant Earnings Growth

If AT&T is so cheap, then why are shares underperforming? The answer lies in slowing earnings growth. AT&T’s quarterly EPS was as high as $0.90 in 2019 but it has steadily declined to $0.55 last quarter.

Image Source: Zacks Investment Research

 

 

3. Industry out of Favor

A stock’s industry group plays a critical role in its performance. AT&T is not the only stock performing poorly in the communications industry; Charter Communications (CHTR) and Verizon (VZ) have also performed poorly. Investors should seek disruptors and avoid legacy industries. For example, Advanced Micro Devices (AMD), a beneficiary of the artificial intelligence (AI) revolution, grew earnings by 159% last quarter. Amateur investors must learn that Institutional investors will pay a premium for growth, especially in bull markets.

 

4. A High Dividend Yield is a Trade Off

New, inexperienced investors often get sucked into buying a stock because it has a high dividend. Pharmacy company Walgreens Boots Alliance (WBA) is a perfect example of why a high dividend does not ensure “safety” or steadiness in a stock. WBA pays a juicy 6% dividend, yet shares are down 46% over the past year!