Caught in a Trap and Can’t Walk Out: Value Traps

By: Steve Rubis

Novice investors often get caught in the quintessential value trap. Novices usually identify a few key metrics that they determine to be important. Then these metrics are applied to some stock and ultimately this analysis will yield some possibilities. The problem is that the method described above can and will yield horrible results. Investment analysis cannot be performed in a vacuum, and multiple variables must be considered. Equity valuation is a sound starting point for generating investment ideas; however, investors must seek more information before making a purchase.

Here at Stock Research, we believe that equity valuation is a sound starting point for investment decisions. The relationship of purchase price and underlying value are of primary concern in our framework. Utilizing valuation as a starting point immediately deciphers over valued equities from under valued equities. The reason valuation of primary importance is the theory of “margin of safety” (Graham). Equity valuation should only be a point of departure especially if an investors wishes to avoid a value trap.

Currently, two industries illustrate the allure of a value trap. A value trap occurs when the underlying characteristics and valuation of an equity security suggest that the company is undervalued. The two industries in question are Mortgage Investments and Residential Construction. Each of these industries performed beyond expectations during the housing bubble. The recent change in climate for interest rates has adversely affected these industries. Interest rate hikes, coupled with a broad sell-off in the market, sent shares in each industry reeling.

The recent plunge in prices makes many of the stocks in each industry look quite cheap. New Century Financial Corporation (NEW) is the best example of a current value trap.

Currently, NEW trades at the following metrics:
P/E: 0.75
P/S: 0.21
P/B: 0.13

Its competitor Nova Star Financial (NFI) trades at:
P/E: 2.36
P/S: 0.60
P/B: 0.32

Each company’s book value is substantially above price:
NEW
Book Value: $37.31
NFI
Book Value: $14.17.

The unsuspecting novice might be led to believe these stocks are incredible bargains. Such a conclusion would be spurious and cause quite a bit of harm.

Investors must look at information aside from valuation in order to determine whether to purchase a security. Most investors can combat the value trap with two techniques: reading the financial news and company reports, and applying tests such as the Altman Z Score. The first source gives the investor an understanding of the climate in which the company operates, which will illuminate land mines not shows by valuation analysis. Secondly, the Altman Z Score will give you a barometer on the company’s financial health. This metric has a 90% plus accuracy rating.

Novice investors often look for shortcuts and do not perform a thorough going analysis because incomplete comprehension. Often, certain metrics are selected and applied in vacuum in order to determine investment ideas. It is imperative that investors use valuation analysis as a point of departure, as well as financial news and company reports along with the Altman Z Score to develop a complete profile for an investment opportunity. We cannot gainsay the importance of what Benjamin Graham called a “thorough going” analysis.

The following articles give the background on the sub prime mortgage industry, as well as a link to the Altman Z Score:

USA Today Article on Sub Prime Lending
The Street.com on Sub Prime Lending
Cramer's Take On Sub Prime Lending
Atlman Z Score

Use this website to apply the Altman Z Score to any stock that you are considering for purchase. Remember, if the score is below 1.8, bankruptcy is likely, and above 3.0 is outsanding.