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.
