Question: When looking at cheaply-priced stocks, how do you know which ones are solid value stocks and which ones are dreaded value traps?
Answer: The value stocks eventually recover, whereas the value traps do not.
I realize that my answer is no more useful than Will Rogers’ advice to “Buy stocks that go up; if they don't go up, don't buy them,” and that is precisely my point. There is no hard and fast way to recognize a value trap. At best, trying to identify one is analogous to Supreme Court Justice Potter Stewart trying to identify hard-core pornography. In a landmark 1964 case, he couldn’t precisely define it, but he “knew it when he saw it.”
Even if they are hard to spot ahead of time, value traps are easy enough to define. A value trap is a stock whose price looks cheap relative to earnings, sales, dividends, or some other metric, yet continues to stay cheap indefinitely. In the worst cases, the underlying business conditions deteriorate and the stock enters a downward spiral.
Any investor who follows a value approach has fallen into a value trap or two. If you haven’t, you will. It comes with the turf.
Even demigods like Warren Buffett fall into the occasional value trap, including Berkshire Hathaway (BRK-A, BRK-B) itself. Though Buffett’s empire still carries the name “Berkshire Hathaway,” the original company was a textile mill whose economics were so bad that not even the great Buffett could save it.
Now that I’ve told you that there is no fool-proof way to avoid value traps and that, no matter what you do, you’re still going to fall into a couple of them, I want to offer one piece of advice that might help you to skip at least one or two in your investing career: Consider the Sector.
What are the competitive dynamics? In certain industries—such as consumer staples, utilities, and telecom service providers—demand tends to be relatively constant. Stock prices fluctuate, of course, and sectors go in and out of still with investor preferences. But the underlying businesses tends to be stable and predictable, and stocks in these sectors tend to pay decent dividends.
Yes, during a recession, some consumers may buy generic bandages instead of Johnson & Johnson (JNJ)-brand Band-Aids, and if it really gets bad they may conserve electricity or trade down to a cheaper mobile phone plan. But your risk as an investor of getting sucked into a downward spiral are minimal, and even if the stock stays cheap for far longer than you expect, you’re often getting paid handsomely to wait with the dividend.
Now consider wild world of energy, materials and technology. We’ll start with natural gas exploration companies. Chesapeake Energy Corporation (CHK) sells for just 6 times earnings and 0.8 times book value, measures that would seem cheap to any good value investor.
Yet there is a big problem here. The market is absolutely awash with new supplies of natural gas, and the price of natural gas continues to scrape along near record lows. This is a fundamental supply/demand imbalance that may take years to fix. Investors expecting to see an improvement in the share prices of gas companies like Chesapeake probably shouldn’t hold their breath.
Technology is another sector in which it can be hard to separate a good value stock from a bad value trap. Consider the case of Research in Motion (RIMM)—a value trap that ensnared yours truly.
RIMM was one of the cheapest companies in the world, at one point in time trading for just 3 times earnings and half its book value.
My thinking when I bought RIMM was straightforward enough. While the company was losing the smart phone war to Apple (AAPL) and Google (GOOG), it had a strong and growing services business with sticky revenues, a strong and growing presence in emerging markets, and a rock-solid balance sheet. At the price at which it traded, RIMM didn’t have to win the smart phone war in order to be a good investment; it merely had to survive.
In most industries, this would have been sound thinking. But in technology, where platforms are everything, it doesn’t hold. Much like the Game of Thrones, with technology platforms you win or you die.
Shrinking market shares for your platform beget further shrinking market share. Retailers don’t want to take up shelf space better used for more popular products. Carriers don’t want to offer incentives. Programmers don’t want to write applications for a shrinking platform. Rather than a gentle decline, you get a sudden collapse. Case in point RIMM.
Not all cheap tech companies are value traps, of course. Microsoft (MSFT) and Intel (INTC) have both been cheap for years, though both have strong underlying businesses nearly impervious to competition and both have been rewarding shareholders with a high and growing dividend.
In investing, for every supposed rule there is an exception. As much as we would like for it to be, this is not an exact science.
In the end, the best defense against a value trap is emotional discipline. Look at your investments critically and don’t make excuses when they fail to perform. Use stop losses when appropriate. And be honest with yourself when you ask the question, “If I didn’t already own this stock, is this something I would want to buy today, knowing what I know?”
Oh, and follow Will Rogers advice about avoiding stocks that don’t go up.