How to avoid value traps
A value trap is a stock that looks cheap but isn’t. Situations that create value traps for value investors to watch out for:
Stocks in cyclical industries such as manufacturing and construction often show significant earnings growth during a boom, and most of that earnings disappear when the season ends.
Stocks in areas that emphasize intellectual property often become value-creation traps. For example, if a pharmaceutical company has a well-selling drug but loses patent protection on it in the near future, much of its profits can quickly disappear. It’s the same with a technology company that is a pioneer in a new industry but has no way to protect itself from the competition.
To avoid value traps, remember that when valuing stocks, the future of a company is more important than its past. If you focus on the company’s prospects for sales and earnings growth in the coming months and years, you will be more likely to find a security that will make a profit.