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Sometimes a stock which may look like a value stock due to a major drop in price, but which is not actually undervalued. Such stocks attract investors who are looking for a bargain because such stocks are comparatively cheaper than other stocks. The trap springs when investors buy stock of the company at low prices and the stock continues to drop further. This is known as “Value Traps”.
The stock price may have fallen due to its circumstances, and it may actually continue to fall. In order to avoid value traps, investors should study not only the stock price but also financial information about that company.
Signs of value traps:
1. A company is at top of operating cycle and still in problems
2. Management compensation structure is not changing even if the stock is declining
3. Business keeps losing market share, although the industry is doing well
4. The capital allocation process is not changing fast enough.
5. Management’s near-term goals are not achievable, and/or managers have failed at the majority of prior year goals.
6. The company have more financial leverage than it can sustain.