5 Value Traps to Avoid Right Now

History’s greatest investor, Warren Buffett, has two simple rules.

  • Rule #1: Never lose money.
  • Rule #2: Never forget rule #1.

A big, sarcastic thank-you, Warren!
Sure, practically everyone has lost money in this market -- including Buffett. But take it easy on the Oracle here, because he’s dead-on. Buffett’s intense focus on not just investing in great opportunities but avoiding terrible ones has been the key to epic success.

Avoiding soul-sucking investments -- what we investing nerds dub “value traps” -- is hardly rocket science. Yet, incredibly, I see investors new and salty alike make the same mistakes over and over again, breaking Buffett’s rules and walking right into what seem like obvious value traps.

Having spent way too much time thinking about it, I’ve concluded that there are five primary categories of these dreaded mistakes. Avoiding these five traps will save you time, money, and more than a little heartache.

1. The quarter-life crisis
These are a real heartbreaker. You find a dominant company whose once sky-high growth has stalled, and its shares along with it. “TechWidget Corp. is trading at only 15 times earnings right now, only half its five-year average!” you say. “Its earnings have doubled over the past five years, but the shares are down over the same time period. Sounds like a steal!”

Snap! You just walked into a value trap.

Investors falsely believe that names like Dell or eBay (Nasdaq: EBAY  ) will see their relative valuations return to their headier days. They won’t.

Why? Captain Obvious would say that growth has slowed, technology evolved, and competition emerged. But all that misses the real reason. Instead of returning incremental profits to shareholders via dividends, such companies wreck shareholder value by chasing growth through overexpansion and high-profile acquisitions. Oh, and the ill-timed share repurchases that exist primarily to juice per-share earnings and help sop up all that stock option-driven dilution.

Steer clear of flailing tech titans until they’re willing to follow the lead of Microsoft (Nasdaq: MSFT  ) and Oracle (Nasdaq: ORCL  ) into dividend-paying adulthood.

2. The soaring cyclical
Here’s the rub about cyclical stocks: Their valuations are counterintuitive. They always look the cheapest when they’ve reached their priciest, and look priciest when they’re reached their cheapest.

Take nearly any oilfield service stock from last summer as an example. Transocean (NYSE: RIG  ) looked dirt cheap via a crude, PEG-style valuation. But savvy investors know that cyclical companies’ profits mean-revert, which is why cyclical stocks’ P/E multiples stay low during booms and high during busts.

In other words, you should be looking at cyclical stocks as their P/Es expand, not shrink.

3. The small-cap Methuselah
The six-year small-cap bull run that came crashing to a halt last year was a painful reminder of a little-known value trap: the Small-Cap Methuselah.

Century-old small-caps you’d never heard of were wrapping up five-year runs of 20% annualized earnings growth. Analysts went gaga, extrapolating those growth rates forward like the party would never end. Valuations followed suit. Gaga analyst, meet mean-reversion.

You won’t find long-run compounding machines within the small-cap space. Show me a company with a long, proven history of creating serious shareholder value, and I’ll show you a mid- or large-cap stock.

4. The too-high yielder
A company usually has a high yield (think above 7%) for one of three reasons:

  • It has limited growth potential, so managers return as much cash as they can to shareholders (think regional telecoms).
  • The company is in a clear state of decline and investors expect a dividend cut (think newspapers).
  • The company is in a tax-advantaged structure that doesn’t allow it to retain much capital (think REITs, MLPs, or BDCs).

Broadly speaking, a high payout is a good thing. There’s a fine line, though. At Motley Fool Income Investor, we’re looking for that sweet spot where an attractive payout meets rest-easy status.

Take my most recent recommendation, Procter & Gamble (NYSE: PG  ) . The stock’s yield of 3.5% is near a multi-decade high despite the company’s underlying earnings power remaining unchanged, if not improving. That’s low-hanging fruit for the income-loving investor.

5. The unopened book
I can already see the Ben Graham fanatics gearing up to peg me with tomatoes, but hear me out. Book values need to be adjusted -- especially heading into and during recessions.

Acquisition-happy companies inevitably end up slashing the goodwill they’d booked while making bloated acquisitions in the years previous. The book values of asset-centric plays (homebuilders, natural resource producers, etc.) also need a good tweaking to reflect the depressed values of those assets. And financials, well, what can I say? Just ask any Citigroup (NYSE: C  ) or AIG (NYSE: AIG  ) investor about the ease of assessing their balance sheets.

Don’t get me wrong: I’m all for buying stocks on the cheap. We do just that at Income Investor. But there’s a catch: We’re only interested in good values if they also happen to be great businesses, companies with years of exceptional performance behind and ahead of them. And, of course, ones that pay us to wait for our thesis to play out.

But I digress.

Wrapping the traps
To recap, you can smooth and improve your returns if you:

  1. Avoid the stalled-out growth stock undergoing a quarter-life crisis.
  2. Steer clear of hot small-caps with blah track records.
  3. Don’t get tripped up by seemingly cheap soaring cyclicals.
  4. Think twice about the yield that looks too good to be true.
  5. Don’t lean on inflated or unadjusted book values.

You’ve probably picked up on an underlying theme here: You need unconventionally conventional thinking if you want low-stress success in the stock market.

Looking for great, simple-to-understand businesses at good prices is the easiest way to avoid stepping into a value trap -- and bag great returns besides. That’s what I do alongside advisor James Early over at Income Investor, and more than 85% of our active picks are beating the market. You can see all of our recommendations free for 30 days -- just click here to get started. There’s no obligation to subscribe.

Senior analyst Joe Magyer owns no companies mentioned in this article, though he’s planning to nab a few. Microsoft, Dell, and eBay are Motley Fool Inside Value recommendations. eBay is also a Stock Advisor recommendation. Procter & Gamble is an Income Investor recommendation. The Motley Fool owns shares of Procter & Gamble. The Motley Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (166)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 24, 2009, at 2:26 PM, nottheSEC wrote:

    Good article well written and food for thought. IMHO one thing deep water drilling RIG is a bad example of an oil service stock company. You might want to try NBR or WEL or GW before the merger with PDS or any land driller or Gulf of Mexico driller. It is a specialty company much like NOV which build rigs RIG is basically in a handful of companies that does deep water drilling. I will agree specialty or not the are tied into the price of crude. My opinion ...J

  • Report this Comment On April 24, 2009, at 2:36 PM, nottheSEC wrote:

    Rig is a bad example imho of just an oil service companies. I will say Mr Market agrees with you and unfortunately ties RIG in with the price of oil Most basic oil service companies are land riggers or Gulf of Mexico riggers i.e SPN or WEL. Specialty companies in this sector include NOV which builds rigs, RIG which does deep water exploration everywhere available and I believe hard to reach extraction ,DWSN which is the leader in seismic.Specilaty companies have few and/or small niche competion i.e TGE for DWSN . IMHO and FYI ...J

  • Report this Comment On April 24, 2009, at 2:41 PM, nottheSEC wrote:

    Sorry about the double post.This glich we are having lately. The first appeared as it had not posted.

  • Report this Comment On April 24, 2009, at 3:42 PM, retry77 wrote:

    I'd have to disagree with "capt. obvious" about RIG, which is not a cyclical, and works off long term contracts. RIG, like all others got killed Sept. 2008 and now it's coming back.

  • Report this Comment On April 24, 2009, at 3:49 PM, nottheSEC wrote:

    Retry77, Mr. Magyer did you read Seeking Alpha's article on Oil service companies trading close to book value and it being a great time to invest While I am not as "gung-ho" if that is half true RIG, NOV & DWSN are best companies in the sector. Article below all best...J

    http://seekingalpha.com/article/132892-interview-with-matt-b...

  • Report this Comment On April 24, 2009, at 5:13 PM, TMFJoeInvestor wrote:

    I actually think RIG looks pretty appealing at recent prices. To your comments about its cyclicality, though, I'd have to disagree.

    Sure, Transocean's deepwater contracts give it reduced exposure to the near-term swings of oil and gas prices, but that's only to a point. Afterall, I don't think it is any coincidence that dayrates went through the roof as oil prices skyrocketed into mid-2008, or that those same rates have softened a bit since oil has crashed.

    Moving past that, though, I'd also keep in mind that jackups (which are extremely sensitive to drilling activity) represented over 30% of Transocean's contract drilling revenues last year, and midwater floaters were another quarter or so.

    So that's all to say, yes, Transocean is a cyclical whose fate is tied to the price of oil, though less so than more marginal players in the space who lack those sweet deepwater contracts. Just sayin'.

    Best -- Joe

  • Report this Comment On April 25, 2009, at 12:08 AM, courtneTHEgreat wrote:

    Nice article; short and to the point. I would like to add that BAC (BofA) like stocks will not return to pre- issue values, just yet, due to credit and employment issues. This is linked to housing.... Also, are banks lending to bring in money, yet? With that being neg. the pos. side is dividends have been cut and the finance charge and other fees on credit cards are very high. This brings in tons of money to banks... which makes their bottomline look good. AND the free money that Uncle Sam is giving away helps too, emotion-removed. AND moving Preferred to Common shares... WOW! Are they making money here too? There are several tricks up the Corp-Gaint's sleeve. So be positive during the Great-Depression of '09/'10.

    So, once the dust settles, in 2-5 years, :-) the companies will be hitting record highs again and staying there. But this is the way I see it.... Next major drop is in Sept/Oct 09, I perdict.... If not then, I expect a ho-hum holiday season and a lead-foot January! (hello 5200 DOW?)

    So, what can we do to fix this mess?

  • Report this Comment On April 25, 2009, at 12:58 AM, BellasPosting wrote:

    Finally! A sane post about eBay. EBay brags about having three billion cash, but I see no dividend in sight. They'd rather spend their cash on buying out competitors, rather than beating them fair and square. Honestly, did eBay need to buy Stub Hub, Stumbleupon or Bill Me later? Of course not. EBay needs to cut down on the endless gobbling up of companies and offer a dividend instead. They'll see their stock go much higher if they do that.

  • Report this Comment On April 25, 2009, at 1:30 AM, paultaut wrote:

    The Government says that they are buying the Toxic assests because they can hold them Long enough to make a Profit.

    If you Eliminate FASB 157 entirely, the Banks can quarantine them indefinitely too. They will make a profit. They can shove them back where the Sun don't Shine and wait, just like the Government is willing to do.

    Let the players pay back what they can. Take over those that can't provide a time frame for pay back. Use the leftover and returned funds as small business tax credits for new hiring, make it enticing.. Giv the people hope instead of the constant drivel coming out of the Government Machine which Speaks ou of both sides of their Mouths.

    Barney Franks: " Well, give the money back. "

    Geithner/Obama: "We don't want you to give the money back."

  • Report this Comment On April 25, 2009, at 1:42 AM, paultaut wrote:

    What is the difference between cheap and cheap but valuable? In my opinion, it is future viability.

    Will the goods.services be needed regardless of economic conditions. For instance, I just bought WD40 under $25, the yield is only 4% but who doesn't have a can of it available somewhere at home? Will lubricants be needed for the Wind Farms of the future?

    Look for beaten down stocks like this.

  • Report this Comment On April 25, 2009, at 8:46 AM, JSinvestmentguru wrote:

    During the present hard times, comsumers probably don't really need to buy anything except ipods and Mac computers.

  • Report this Comment On April 26, 2009, at 7:29 PM, dbbfool63 wrote:

    I do not think anyone can say what will or won't happen in this market regardless of the company or any part of what the balance sheet says.

    What no one would have thought would happen last year on that special day that trillions of dollars were coming out of every account imaginable regardless of whether it was insured or not, DID HAPPEN.

    Yes, I am a big believer in fundamentals, balance sheets, and management as well as where the economy is headed.

    But we also have a few new things to consider that need to be gotten a handle on.

    1. The scams with the people involved, inside and outside of the companies.

    2. Very irresponsible and unprofessionally written headlines as well as the articles that usually follow. Example (NT).

    3. Similar to number 2 except the extremity of Fear used by anyone from the government, analyst, and others like the blogs posted on hear as well. When fear is exploited the way that is was, nothing else about any company seem to matter.

    Considering it was said on that special day that the whole central banking system would have been shut down within a few hours at the pace money was coming out, that should be enough to make my point.

  • Report this Comment On April 27, 2009, at 5:11 AM, ando9999 wrote:

    Hi,

    I think it's a little harsh to throw EBay into this article.

    The new CEO is shedding these pointless buys and IPOing Skype in 2010 (Skype is now booming anyway, it was only a few days ago a major UK mobile phone provider announced they are providing Skype calls for free using their sims, and their new ad campaign is on a par with Apple's top quality ads). But Skype doesn't fit EBay's business and it's good to see EBay getting rid of it. Although value/growth investors don't normally like acquisitions, PayPal I feel was a good buy, fits EBay's business perfectly. StumbleUpon, ...what was she thinking!!!?? :o)

    I don't like the fact that EBay and Dell are mentioned in the same breath, Dell's numbers are terrible, EBay's numbers are as solid as a rock!

    I'm not really an income investor, I'm a value investor, so I'm not too interested in dividends. This article was passed onto me by a colleague and he asked me to comment, I think he's looking forward to the flames....

    Andy

  • Report this Comment On May 02, 2009, at 1:21 AM, ozzfan1317 wrote:

    I think Dividends are Key in any Portfolio. But a combination of strategys might be helpful.

    Also not all High Dividends are created equal if the company is in the energy sector with enough free cash flow 8% isnt out the question.

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