Value investing will work if investors can weed out the ‘value traps’

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Value investing is an investment strategy that aims at stocks that are underappreciated by investors and the large market. The stocks that value investors seek typically look cheap compared to the underlying revenue and earnings from their businesses. Investors who use the value investing strategy hope that the stock price will rise as more people come to appreciate the true intrinsic value of the company’s fundamental business.

Bank of America is in the path of downtrodden value investing, but the Wall Street firm is warning investors about value traps. On last Tuesday Savita Subramanian, equity and quant strategist told clients on that they prefer value to growth for a multitude of reasons, spanning macro and micro, but watch out for traps.

While high flying growth stocks have led the major averages from the depths of the coronavirus recession, Bank of America said value investing is still alive. Firms believe that the valuation gap between expensive and cheap stocks is its largest in years, setting the stage for undervalued companies to catch up with the technology. Subramanian added that traditional cyclical industries like Household Durables, Autos, Metals and Mining, Construction Materials, and Semiconductors screen as great opportunities, backed by improving fundamentals as well as price momentum. Most of the investors need to separate the quality value stocks from the duds.

The defining characteristic of a value stock is that it has an inexpensive valuation compared to the value of its assets or its keys such as revenue, earnings, or cash flow. However, the best value stocks also have other attractive characteristics that make them appealing to investors who use value investing strategies. Value investing requires a lot of research. That’s enough to intimidate many would-be value investors, but there are some tricks you can use to identify good value stocks. By fully understanding the many ways to value a company and assess its business prospects, through this way Investors can weed out inappropriate stocks more quickly.

A value trap is a stock that looks cheap but isn’t. Stocks in cyclical industries like manufacturing and construction often see their earnings rise substantially during boom times, only to see much of those earnings disappear when industry conditions cool off. When investors see a possible bust coming for a stock, its valuation will look very inexpensive compared to recent earnings but much less so once earnings fall during the weaker part of the business cycle. Stocks in areas that emphasize intellectual property are prone to become value traps. 

To avoid value traps, the future of a company is more important than its past when valuing a stock. If investors focus on a company’s prospects for sales and earnings growth in the months and years to come, it will be more likely to find true value stocks.

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