Beware The Value Trap

[Editor’s Note: Louis Basenese is the Associate Investment Director of The Oxford Club and regular contributor to Investment U. He is one of the top analysts and most sought after speakers on financial topics in the country.The following article first appeared in Investment U. But because of the quality, we wanted to share it with Money Morning readers]

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...

1. 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.

1. 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.

1. 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."

1. 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.

1. Is the company just as "cheap" based on the future?
   At first glance Eastman Kodak Co. (EK) appears dirt cheap, trading at a price-to-earnings (P/E) ratio of 2.96. But don't be fooled. Or get too easily excited. Remember, the P/E 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 P/E ratio is similarly attractive. (FYI - Eastman's is not. It trades at 27 times forward earnings. Hardly cheap.)

1. 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.

1. 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.
              
2. 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.

1. 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.

1. 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 Inc. (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 (FRE)) and Carl Icahn (with Yahoo! Inc. (YHOO) and Advanced Micro Devices Inc. (AMD)).

But at the very least, these 10 questions will ensure you never buy blindly, or on price alone.

[Editor’s Note: For additional insights on value investing, check out Investment Director Keith Fitz-Gerald’s recent special investment research report on the same topic: The Five Keys to Value Investing Profits.]

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