Unlike Canadian value stocks, investing in a value trap, even though it may seem like a good deal, is a mistake to avoid

The meaning of “screaming buy” is different for every investor. Some use it when they think a stock (oftentimes perceived as Canadian value stocks) is virtually certain to go way up in a hurry when the market comes to its senses. A stock may seem like a screaming buy to some investors if it has gone up a great deal on good news, and the good news seems likely to continue. It may also seem like a screaming buy if it has dropped a great deal, and the drop seems out of proportion to whatever bad news seems to have caused the drop.

“Value trap” is much more specific. The term suggests that stocks look like Canadian value stocks, say, based perhaps on statistical measures, but that they are likely to get much cheaper. Those stocks may have an unusually high dividend yield, an unusually low p/e (per-share price-to-earnings ratio), a low ratio of stock price to book value, or any of several other conventional signs of per-share value.

Any of these measures can make it seem like a stock is a bargain–Canadian value stocks. But in fact, any of them can simply be due to a low stock price that is the result of selling by well-informed investors who recognize a dismal long-term future.

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Going deeper into the concepts of screaming buy and the value trap

Successful investors find use for the term “screaming buy” rarely—every few years, if that. That’s because they’ve learned from experience that in the stock market, things are never certain. That’s why we always advise you use our Successful Investor approach to build a balanced, diversified portfolio of high-quality stocks. That makes it easier to spot Canadian value stocks when they do emerge.

A value trap can make a stock look like a bargain. But in fact, a stock may be statistically cheap as a result of selling by insiders or well-informed investors who recognize its dismal long-term future.

Too much reliance on simple value measures alone in stock analysis can lead you into a costly value trap

You need an eye for value to be a Successful Investor. But focusing on value measures alone can steer you into unsuccessful investments that are sometimes referred to as “value traps.”

Another way to fall into a value trap is to put too much faith in the value of a brand name. A strong brand can sell a lot of a strong product, or keep an over-the-hill product going long after competitors have faded. But even the strongest brand name can only do so much.

4 tips for avoiding value traps (and finding Canadian value stocks):

1. Determine if the company has freedom from business cycles? Demand periodically dries up in “cyclical” businesses such as resources and manufacturing. You can hold some value stocks from those sectors, but look as well for companies, especially in manufacturing, that have broad product lines or products that are indispensable.
2. Review a company’s dividend record over the last 5 to 10 years. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying stocks, you’ll avoid most frauds.
3. Review a company’s finances going back 5 to 10 years. The types of investments we focus on have a history of profits going back for at least that long. Companies that make money regularly are safer than chronic or even occasional money losers.
4. Determine if the company has hidden asset in their relationship with loyal customers. After a series of satisfactory dealings, long-time customers develop a level of trust that makes them receptive to related offerings from the company. This customer loyalty can help businesses mitigate the value trap.

Bonus Tip: A big or key idea may lead investors into another kind of trap

Many investors instinctively try to spot these big ideas. Most instead get sidetracked by ideas that are eye-catching but transitory. Rather than give you a clue to the market’s direction, these transitory ideas may distract you from what’s really going on. For example, when markets rise for a long time, some investors lose the habit of trying to spot the big ideas that are driving the rise. Instead they switch to searching for what you might call “The One Big Signal” that tells you it’s time to sell. You’re especially prone to falling into this trap if you’ve stayed out of the market during a long rise in prices.

How have you been able to distinguish between true Canadian value stocks vs value traps?

How much of your portfolio have you lost in value traps since you began investing?