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Value Investors – Beware The Value Traps
by Louis Basenese, Advisory Panelist
Associate Investment Director, The Oxford Club
Wednesday, December 3, 2008: Issue #895
Value investors, consider this your warning… With thousands of stocks down 50% (or more), investors are salivating over the bargains. But for every true deal, there are at least three “value traps” – stocks destined to languish at depressed levels indefinitely. Or worse, get cheaper still.
Think Kmart here. In late 2001, it became the poster child for value investors. They argued it was dirt cheap based on countless metrics like book value and sales. And it was destined for a historic turnaround.
Sure enough, the stock went from the bargain bin to the trash heap, as the company filed bankruptcy in early 2002.
So before you go bargain hunting in this market, arm yourself with this list. It could be your only chance to avoid getting snared by the countless “Kmarts” begging for your investment…
Value Stocks & Value Traps
In theory, a value stock is a beaten-down company that’s:
- 1. Cheap compared to its earnings, its competitors and/or some other relevant benchmark
- 2. Poised for a turnaround.
In contrast, a value-trap is simply:
- A beaten-down company that’s cheap compared to its earnings, its competitors and/or some other relevant benchmark
- That never quite turns around.
Unfortunately, no formula exists to calculate when, or if, a turnaround will ever occur.
10 Questions To Help Value Investors
These 10 questions should help any value investor. And ultimately, keep you out of most value traps…
- Is there a near-term catalyst? First things first, if there’s nothing on the horizon – like a new product launch, key marketing arrangement, a shake-up of the executives, the conversion of a massive order backlog, etc. – we shouldn’t bother. Companies and stocks need catalysts in order to advance. If none exist in the next 12 to 18 months, chances are the stock will be stuck in neutral, or worse, reverse.
- What are insiders doing? Nobody knows the company – and its future prospects – better than the insiders. If they’re not salivating over the “cheap” prices and backing up the truck, we shouldn’t either.
- Is the company addicted to debt? Too much debt magnifies the impact of tough times. As sales decrease, interest payments take up more and more of the company’s earnings. Not to mention, unwinding leverage is a time-consuming process. So even if the company boasts new, fiscally responsible management, beware. Or as Warren Buffett observes, “When a management with a reputation for brilliance takes on a business with a reputation for bad economics, it’s the reputation of the business that remains intact.”
- Does the dividend yield seem too good to be true? Value investors love to tout they “get paid to wait” for a turnaround. Granted, many stocks do maintain their dividends through a downturn. But countless others don’t. They slash or cancel them altogether, just to stay in business. No matter how tempting, tread carefully when the dividend yield hits double-digit levels.
- Is the company just as “cheap” based on the future? At first glance Eastman Kodak (NYSE: EK) appears dirt cheap, trading at a price-to-earnings (PE) ratio of 2.96. But don’t be fooled. Or get too easily excited. Remember, the PE ratios cited on most financial websites are historical. And as investors, we don’t care what a company was worth… we care about what it will be worth. So before you buy, make sure the stocks forward PE ratio is similarly attractive. (FYI – Eastman’s is not. It trades at 27 times forward earnings. Hardly cheap.)
- Which direction is the company’s market share headed? A general economic slowdown is one thing. But when a company’s losing market share, too, that’s an indication that a competitor has a better mousetrap. And while economic growth is cyclical, market share is not. Even if the economy or industry turns around, chances are the company’s market share won’t.
- Does the company operate in a highly cyclical or moribund industry? If you go hunting in a highly cyclical industry (like semiconductors) you’re asking for trouble. Same goes for industries destined for obsolescence (like print media). To win with these stocks, you need both the company’s misfortunes and the industry’s to reverse course.
- How’s the free cash flow? Earnings can be massaged, manipulated or completely fabricated. But cash cannot. So make sure free cash flow is stable, or growing. If nothing less, it provides management with a little wiggle room, or margin of error when considering ways to speed up a turnaround.
- Is the stock liquid enough? Just like insiders provide support to share prices, so do institutions (mutual funds, pension plans, hedge funds, etc). Both groups can move stocks prices quickly and significantly. However, many institutions can’t or won’t buy stocks trading for less than $10, with a market cap below $1 billion and/or that don’t trade several million dollars worth of shares each day. Without the potential for institutional ownership, a quick rebound in prices becomes less likely.
- Does the company have a sustainable competitive advantage? For a stock to turnaround we need the company to thrive, not survive. That’s not possible without a sustainable competitive advantage. So stick to companies like Apple (Nasdaq: AAPL) that are light-years ahead of the competition in terms of design, market share, new product offerings and/or technology.
In the end, don’t kid yourself. Detecting a value trap is no easy task. Even the best investors occasionally get snared. Think Bill Miller (with Countrywide and Freddie Mac (NYSE: FRE)) and Carl Icahn (with Yahoo! (Nasdaq: YHOO) and Advanced Micro Devices (NYSE: AMD)).
But at the very least, these 10 questions will ensure you never buy blindly, or on price alone.
Happy bargain hunting,
Lou Basenese
Today’s Investment U Crib Sheet
“How do you catch a falling knife without hurting yourself? You don’t.”
It can be tough to watch an asset go into a freefall. Especially if you just purchased it at a price you felt couldn’t possibly go any lower. It can be harder to watch when the rest of your portfolio does the same. However, that doesn’t mean you shouldn’t look for undervalued investments.
Our third Pillar of Wealth is perfect for bargain hunting.
Pillar 3: Understand Position Sizing
Knowing how much to invest in each and every situation is crucial to building long-term wealth. Position sizing ensures that even if a number of your investments turn sour, you’ll never lose your shirts.
As a guideline, we recommend investing no more than 4% of your equity portfolio in any particular stock. If you want to be conservative, invest less. If you want to be aggressive, invest more – but not too much more.
This strategy makes sense in your transaction amount as well. By building up a new position over a couple of trades you can minimize the risk that your initial purchase was at the high of the day, week or year. It allows you to utilize dollar-cost-averaging to lower your cost per share. However, it’s your personal preference on how far apart to spread purchases – minutes or days.
Position sizing defines exactly how much of any stock you should buy… and limits your losses from ill-timed purchases.
The Four Pillars of Wealth are the foundations of our philosophy and the basis behind successful investing. Quite simply, it works. And it’s why Alexander Green went over our fourth Pillar of Wealth on Monday. To get his five basic steps you can take to reduce your taxes this year, check out Investment U Issue #894, Tax-Managing Your Portfolio: There’s Still Time to Cut Your 2008 Taxes.
- Top 10 Value Traps
- Investing In Dividend-Paying Stocks: A “Strong Buy” Since 1935
- Buy “Low-Density” … How to Take the Guesswork Out of Valuing Stocks
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In addition to being the foremast expert on small-cap stocks, Louis is also well versed in special situations including IPOs, mergers and acquisitions, spinoffs and contrarian investments. His commentary has been featured in several media outlets, including MarketWatch. And he's also a top-rated speaker at financial conferences throughout the country. 
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