The Rookie Investor: Learning not to get caught in the value trap

Sometimes a cheap stock is cheap for a reason, not just because it’s good value…

woman wearing an iWatch holding an iPhone
Imagination gets a royalty of about US$0.30 for each iPod, iPhone and watch that Apple sells

It’s been a busy few weeks since I last wrote this column; splashing the (inherited) cash on Caribbean holidays is a hard life.

Anyway, the real world is calling again so back we must go.

Back in April, I took a £1,000 punt on semi-conductor intellectual property licensor Imagination Technologies Group (LON:IMG).

You may recall that the group slumped by more than two-thirds at the start of that month after tech giant Apple Inc (NASDAQ:AAPL) said it was going to stop using its IP in its new products by 2019.

Apple is Imagination’s largest customer and was responsible for around half of the firm’s revenues last year but, even so, the sell-off seemed a bit overdone to me.

Even with a limited knowledge of processor chips, to develop every one in-house would be a time-consuming and expensive process; even more so when you have to avoid infringing various patents.

I took a chance that the two might resolve their differences or, more speculatively, that Apple (which already owns a small stake) or someone else would look to take out Imagination on the cheap.

None of those scenarios have come to pass yet, but I’m up around 15% at the moment so I might have got lucky and caught the falling knife so to speak.

BT not quite dialled in

You also might remember, I bought BT Group plc (LON:BT.A) earlier in the year after its share price suffered a similar fate following the accounting scandal in its Italian business.

Things had looked good for a short while back in March when the share price topped out at around 342p but uncertainty and a lack of trust still exists it seems and the shares have fallen back to below the 300p level, putting me in the red.

Even with the flagging share price, I still quite like my investment to some extent, as BT paid out a 5% dividend last year. 

Value traps

In terms of share price performance though, BT looks like it could be something of a ‘value trap’ and perhaps I didn’t quite understand the difference between cheap and value when buying in.

A classic value trap is when everything about a particular stock – low price-to-earnings ratio, good cash flow, high yield etc – looks like it is good value.

Actually though, their cheapness is a reflection of their inferior quality in some way. Essentially, they’re cheap for a reason and they’re hard to make any money out of because they’re not being bought for less than their true worth.

Whatever you may think of bankers and traders, the stock market as a whole is not stupid and is generally an efficient beast. Except for maybe during a financial crash, shares (unfortunately) are rarely given away on the cheap without a good reason.

Next another example of cheap but not necessarily good value

Next is another example of a stock that is a potential value trap. Its shares have been hammered in recent months after it admitted that profits would struggle over the next year or so.

Despite the difficulties, which the retailer has been pretty open about, everything about Next suggests it would make a good value buy.

It’s forward price-to-earnings ratio is around 9 (less than Dunelm Group PLC’s (LON:DNLM) 14), it remains very cash generative and is using that cash to pay out sizeable dividends.

There are underlying problems though. As Credit Suisse recently pointed out, prices across Europe have remained soft and Next has been forced to cut back its prices even further to try and make up for a poor performance in the first quarter.

On top of that, online retailers like Asos PLC (LON:ASC) and Boohoo.com PLC (LON:BOO) are taking the market by storm and eating into the traditional retailers’ market share.

“We continue to believe that its strategy of expanding UK space is incorrect for a mature retailer and that self-help from Credit, International and Label will diminish, and potentially reverse, over the next two years,” analysts at the Swiss broker recently said.

Then came the punch line: “With earnings, margins and cash conversion continuing to fall we regard Next as a value trap.”

So there you have it. Just because a stock is cheap, it doesn’t always mean it’s good value and it looks like I might have found that out the hard way with BT.

Fevertree and AstraZeneca still going well

As for my other two investments, Fevertree Drinks PLC (LON:FEVR) and AstraZeneca PLC (LON:AZN), they’re both plugging away.

Tonic maker Fevertree has shown signs of fallibility in recent weeks but I was encouraged when the co-founder sold off a sizeable stake to baying institutions.

I’m still undecided as to when I’ll sell this particular stock. Yes it’s expensive and logic would say that the growth has to slow at some point, but if it can crack the US dark liquor market, the upside is enormous.

As for AstraZeneca, the drugs giant has soared since I bought it back in November when a fair few brokers were saying it was fundamentally undervalued.

That right seems to have been wronged with the recent share price rise, but I’m still holding out for the key MYTSIC data which is due out anytime soon.


Fevertree – 211 shares @ £9.50. Currently £16.65.

AstraZeneca – 48 shares @ £42.26. Currently £53.

BT – 328 shares @ 305p. Currently 290p.

Imagination Technologies – 952 shares @ 105p. Now 123p.

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