Definition of value trap

A financial instrument (stocks or bonds) that appears cheap on historical measures or valuation grounds, such as price/earnings ratio, but the price never recovers to fair value. As Warren Buffet said, “price is what you pay, value is what you get".

Such "bargain" investments attract buyers because they hope that the price will go up in future so they will make money. However, the problem is that the stock price can fall again and may never go up unless there is a catalyst.

Let us assume you believe that the stocks from company A are cheap because they trade at 10x 2011 earnings when compared to other comparable companies that trade at 12 x 2011 earnings. The market does not buy company A’s stocks because it does not trust that the earnings estimate for 2011 will be reached. You believe it will be reached and that is why you buy. When company A delivers their first half results, and if they are on track to meet estimates, then you will be right. The rest of the market will begin to assess that company A may reach their targets, and the stock will go up, hence, the first half results served as a catalyst.

Some accounting scandals are value traps.  The idea is to trap or lure enough investors to make the company look good financially.

Some investors bought Parmalat’s bonds in the summer of 2003 on the basis that they were cheap for a company with a strong cash position and balance sheet. [1]

The Italian dairy group collapsed in that year with €14bn ($18.5bn) of debts and entered into bankruptcy protection with investors losing money on this investment.

In 2010, the court found Mr Calisto Tanzi, former chief executive of the company, guilty of fraudulent bankruptcy and criminal conspiracy.

The collapse of Parmalat, dubbed “Europe’s Enron”, rocked the Italian and European corporate worlds when in late 2003 it admitted an account it claimed to have held at Bank of America with €4bn was a fake. It turned out that the company had been misleading investors about its true value and its share price. Italian pensioners were among more than 100,000 shareholders who lost their life savings in the collapse. [2]

Ex-head of Parmalat jailed for 18 years