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The value trap is one of the biggest dangers that value minded investors, aka bargain shoppers, have to contend with.  It's even worse for contrarians like me who always look for gems in the mud that are hated by the masses.

I recommend having a look at this article by Kapitall editors Eben Esterhuizen and Alicia Sellitti from this week's newsletter.  Eben and Alicia save me the trouble of explaining a value trap, and put it more succinctly I would. They offer some useful hints for identifying value traps, but also make it clear that it's often impossible to tell if you've been tricked by one until it's already too late.


So how do I defend myself against value traps?   In a word, discipline. Investing is a game of survival, and two simple rules can help you escape value traps relatively unscathed.

1. POSITION LIMITS:  Do not put more than 10% of your investing portfolio (or 3% of your net worth) in any one company.  Mutual funds and ETFs are fine if they are diversified, but never more than 10% and 3% for a single company.  I MEAN THIS!  IT IS THE KEY TO YOUR LONG TERM SURVIVAL AS AN INVESTOR.

2. STOP LOSS:  If a company keeps falling even though it seems like a good value, just get out.   There are probably things going on at the company you don't understand. If things turn out to be just fine,  you can always buy back in on the way up.  You'll probably end up buying back at a higher price than where you sold if you buy on the way up.  That's no fun but the missed opportunities will more than make up for the complete losses that hide behind many value traps.

WHERE DO I SEE VALUE?  Big Pharmaceutical Makers are some of the largest corporations on earth. They sport low POP (forward P/E) and high dividends. They've also been completely left out of the market rally.  I don't think there's much of a risk of value traps among the big pharma stocks I own and have attached--but nonetheless, I am still on the lookout.

So let's see how I do with the two rules.

Position Limits:  I have less than 1% of my net worth in each one big pharma stock and I own and my total holdings in sector make up less than 10% of my portfolio.

Am I willing to lose?: Survivors aren't afraid to cut their losses.  Unless the entire market is down, I am ready to sell and reevaluate (at a loss) if they fall 10-20%.  If the stocks fall together with the market I'll hold on.

DISCLOSURE:  I own Eli Lilly, Pfizer, Novartis, Sanofi, Merck, Abbot Labs, AstraZenica, Glaxo Smith Klein and Bristol Myers.  Understand that the stocks above fit nicely into my portfolio, which has many sectors and a mix of stocks, bonds, funds and cash.  You will not know if they are right for your portfolio unless you do your own analysis.

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