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 Corp. 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…
10 Questions You Should Be Asking
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 and 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,
but never quite turns it around.
Unfortunately, no formula exists to calculate when, or if, a turnaround will
ever occur. But, these 10 questions should help. 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.
