Value trap? Growth trap? What to know to avoid getting snagged

Published Wed, Apr 5 20231:46 PM EDTUpdated Wed, Apr 5 20232:26 PM EDT

It's a value trap! No, it's a growth trap! Either way, these two ubiquitous Wall Street terms imply the investment is just not as good as you're being led to believe. Such market traps lure investors in with the promise of returns due to some unique characteristic – in this case, value or growth – but ultimately fail to deliver. Value traps In the case of a so-called value trap, an investor buys a stock on the premise it provides deep value because its valuation is inexpensive relative to the company's earnings or cash flow. The trap, however, comes into play as upside ultimately fails to be realized, or downside proves greater than anticipated because the security was never as cheap as imagined. An investor might see a company trading at 10-times earnings, versus its historical valuation of 15-times earnings, and determine that to be a significant value. But that price-to-earnings multiple alone may not tell the entire story. Regulations could have changed, for example, reducing the company's prospects for future growth – and the stock could simply never see a 15-times multiple again. The same might be said for valuing a company against peers. Some investors might look at Chinese ecommerce platform Alibaba and see many similarities with the U.S. firm Amazon (AMZN), determining Alibaba's valuation should move higher towards that of Amazon over time. But that view would cost investors quite a bit of money, given Alibaba trades in the Chinese market and is regulated by officials in Beijing who can rewrite the rulebook at will. More broadly, a security may stay cheap simply because the business is treading water, as sales and earnings stagnate. As a result, the security in question never provides a meaningful return. The investor's loss is due to the so-called opportunity cost paid by sitting in a security they mistakenly believed was undervalued – the cost of misappropriating funds that could have been put to better use elsewhere. Investors may also face significant downside risk should expected earnings fail to materialize, as is often the case with cyclical stocks. Investors might rush into a name with a low price-to-earnings multiple believing the multiple represents an undervalued business – only to learn that the multiple was low not because the stock price was too low but because earning estimates for the company were too high. That's a trend seen in many oil stocks earlier in the year, whose earnings power fell when commodity prices tumbled. When investing in cyclical businesses, the so-called trap results from investing in the wrong part of the cycle – right before earnings estimates are likely to be revised lower. Growth traps While value traps reel in an investor for a supposedly undervalued opportunity, a growth trap's appeal comes from the promise that a relatively expensive stock will see rapid growth in the future. Essentially, investors justify paying a high valuation based on the view that the valuation will come down rapidly as a company's earnings meet, or exceed, expectations. An investor might be willing to pay 80-times forward earnings on the view that those earnings are set to quadruple in five years. But there are many reasons that's a risky endeavor. Demand could fail to materialize, a disruptor could come along, management could fail to improve profitability as planned or, as we have seen over the past year, the Federal Reserve could ramp up interest rates and shift market dynamics. As investment firm GMO noted in a December 2021 report : "When Value disappoints, markets are mad. When Growth disappoints, they are merciless." With a value trap, you may be stuck until earnings rebound with the next business- or economic cycle, while collecting a dividend in the meantime. But with a growth trap, once those earnings fail to materialize, future years of earnings will likely be revised sharply lower, as the market questions the original investment thesis altogether. With both value- and growth traps, the investing error comes down to a miscalculation of the business fundamentals and future earnings power of a company. That's why at the Club, we believe discipline trumps conviction and that it's more fruitful for investors to focus on protecting downside than capturing upside. (See here for a full list of the stocks in Jim Cramer's Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

The New York Stock Exchange in lower Manhattan on Nov. 24, 2020 in New York City.

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It's a value trap! No, it's a growth trap!