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    Averaging your losses in midcaps, small caps? Beware of value traps

    Averaging your losses in midcaps, small caps? Beware of value traps

    Averaging your losses in midcaps, small caps? Beware of value traps
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    By CNBCTV18.com  IST (Published)

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    Investors with no previous exposure to underperforming midcap and small cap stocks too are buying them, viewing them as bargains at 20-30 percent below their record highs.

    The Sensex and Nifty are hovering near record highs, but scores of investors are licking their wounds from the steep fall in the prices of mid and small-cap shares over the past month. With frontline shares still in an uptrend and the market discounting most negative news, the widely held view is that corrections will be short-lived and second-line shares will resume their climb. This line of thinking is prompting many investors to average their losses in declining stocks by picking up more shares at lower levels.
    Also, investors with no previous exposure to such underperforming stocks too are buying them, viewing them as bargains at 20-30 percent below their record highs.
    Averaging is a good strategy but has to be done with care. Else you might end up walking into what is commonly known as a ‘value trap’ in market parlance.
    These are stocks that may appear to offer value because they are trading at a low valuation compared to peers, but will continue to trade at those valuations for a long time, or even decline further.
    They are called ‘value traps’ because investors are misled into thinking that they can make a good return by investing at those low valuations.
    And they are hard to spot. Even seasoned investors are known to have occasionally fallen for them.
    While it may be hard to avoid value traps altogether, you could ask yourselves a few questions before buying them or averaging your purchases made at higher prices.
    • How steeply have other stocks from the same sector fallen during the same period? If other stocks have not fallen by as much as the one in your portfolio, it is a cause for concern. And even if peer group stocks have fallen similarly, you need to probe further.
    • Is the company into a cyclical line of business? If yes, then check if there are signs of the business cycle having peaked. You will never able to say for sure if the cycle has peaked, but there will be enough telltale signs for you to make an intelligent guess.
    • Does the management have a good track record? A rising tide lifts all boats, so even stocks of companies known to fleece shareholders will do well in a bull market. But when the tide reverses, these stocks will find it had to make a comeback.
    • Did you notice large blocks of insider selling in the stock of late? It is said that insider buying is a more reliable indicator than insider selling, but the setting also matters. Insider selling in a raging bull market often reflects a call on valuations, at least in the short run.
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