A year ago, Alpha Pro Tech Ltd. (NYSE: APT) was trading at about $4. The company’s book value was almost $5 per share.
At first glance, this sounds like a bargain. We’re paying $0.80 for $1 in assets.
The company’s assets were mostly cash and inventory — not creative accounting. There wasn’t any debt. If the company went bankrupt, shareholders should expect something after the assets were sold off.
Why, then, is APT still a $4 stock a year later… with no sign of that changing?
Because it has one big problem… Investors aren’t buying it.
APT might seem like the kind of low-priced stock Adam O’Dell has been researching. But it’s not.
APT is more like one of the stocks Matt Clark wrote about on Monday. It was a value trap.
A value trap is a stock that looks like it offers value, but it really just traps your investment capital in a low-return, or even no-return, asset. If you buy enough value traps, you can’t possibly reach your financial goals — unless your goal is to underperform the stock market in the long run.
Today, I want to show you more ways to avoid falling into value traps — by only buying the stocks that other investors are interested in buying.
A Logical Mistake
Many investors fall into value traps. This is especially common for large-cap dividend stocks.
Their reasoning goes something like this:
- Six months ago, a stock was trading at $100 and offered a dividend yield of 3%.
- The stock price fell 50%. Now it trades at $50. The dividend yield is 6%.
- Investors look at the stock and believe if it was worth $100 six months ago, it’s a bargain at $50.
- They buy.
It was a logical reason to buy, but it turned out to be a mistake.
Often, the stock continues falling, while the true believers say things like: “I still have my dividend.”
Of course, the stock’s decline could signal the company is facing problems. The company cuts its dividend in response.
Now the investor says things like: “It’s only a paper loss. It’ll come back.”
In other words … they’re trapped.
That logic is so appealing that the value trap might sound unavoidable. But it’s not. The truth is, value traps are easy to avoid.
To understand why, we need to think about why stocks go up.
Momentum: The Simple Reason Why Any Stock Goes Up
You may think a stock goes up because the company grows its profits. But that’s not always the case.
Look at the chart below. The blue line is the price for CarGurus Inc. (Nasdaq: CARG) stock. The red line is the company’s earnings per share.
CarGurus doubled its earnings over the past three years, but the stock price fell 15%.
The reason stocks go up actually has nothing to do with earnings. At least, not directly.
Stocks go up when investors buy them. Stocks fall when there are no more buyers. When buyers act with a greater sense of urgency — perhaps, but not necessarily because of growing earnings — prices rise. When sellers are more excited to get out of a stock, prices fall.
Trends really just reflect that dynamic. If a company is performing well, that doesn’t mean the stock price will go up if investors don’t know about it.
Or, there could be other, less noticeable problems.
In the example of CarGurus, investors are worried about management’s ability to execute business plans. The price decline reflects those worries more than the significant progress management made in growing the business. Ultimately, investor behavior determines the price.
CARG is trading with a reasonable valuation. Like APT, its price-to-book value is low and other metrics confirm the stock seems undervalued. But it’s another value trap.
There are hundreds of value traps in the market. Fortunately, there is a simple way to avoid them.
All we have to do is follow Will Rogers’ investing advice: “Don’t gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”
That may sound like worthless advice. But it’s not. You really should only buy the stocks going up, regardless of how well the business is doing.
Momentum indicators can help you measure whether a stock is going up or not. And momentum is the difference between a bargain and a value trap.
As Stock Power Daily readers know, Momentum is one of the factors in the Stock Power Ratings system. The system has a documented history of forecasting which stocks go on to outperform the market in the long run. And it plays a big part in Adam’s new strategy that seeks out the biggest opportunities in stocks trading under $5.
There are many ways to measure momentum. One of the simplest is to look at the Stock Power Ratings score. Other ways include rate of change calculations or more complex relative strength calculations.
The good news is they all work in the long run. As long as you buy stocks that are going up, you are likely to have more winners than losers. And you will avoid value traps.
Until next time,
Senior Technical Analyst
P.S. Adam just eliminated another round of value traps from his $5 Stocks to Watch list. And he’s releasing the last revision of the list — which contains just a few dozen stocks out of the hundreds of initial candidates — for free tomorrow. You can sign up to access it here.
After you do, I encourage you to join Adam for his webinar at 1 p.m. Eastern time. There he’ll detail the top $5 stock opportunities that are uniquely suited to individual investors.
He’s sharing the top names with his subscribers right after the event, and he’ll give you the rare opportunity to join them. Click here to make sure you’re signed up and get Adam’s free $5 Stock Watchlist.