5 Value Traps to Avoid Right Now

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

  • Rule No. 1: Never lose money.
  • Rule No. 2: Never forget rule No. 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 Yahoo! (Nasdaq: YHOO  ) will see their relative valuations return to their headier days. They won't.

Why? For starters, growth has slowed, technology evolved, and competition emerged. But all of that misses the real reason. Instead of returning incremental profits to shareholders via dividends, such companies wreck shareholder value by chasing growth through non-core expansion 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 ready, willing, and able to follow the lead of Microsoft, Qualcomm, and Oracle 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've reached their cheapest.

Take nearly any oilpatch player from last summer as an example. Chevron (NYSE: CVX  ) , Noble (NYSE: NE  ) , Diamond Offshore (NYSE: DO  ) , and Apache (NYSE: APA  ) looked dirt cheap via crude, PEG-style valuations. 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 many 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 one of our more recent recommendations, wide-moat McCormick. Shares of the 800-lb. gorilla of the spice industry are off more than 20% from their 52-week high and boast a CD-topping payout of 3%. Meanwhile, the company's underlying earnings power has remained unchanged despite this recession, if not improved. 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 Freddie Mac (NYSE: FRE  ) or General Electric (NYSE: GE  ) 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. Don't get tripped up by seemingly cheap soaring cyclicals.
  3. Steer clear of hot small-caps with blah track records.
  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 advisor James Early and friends do over at Income Investor, where our average recommendation yields 5.4% and has beaten the market by 5 percentage points. You can see all of our recommendations free for 30 days -- just click here to get started. There's no obligation to subscribe.

This article was first published April 24, 2009. It has been updated.

Senior analyst Joe Magyer owns no companies mentioned in this article. Microsoft is a Motley Fool Inside Value recommendations. McCormick, as mentioned, is an Income Investor recommendation. The Motley Fool's disclosure policy lives vicariously through itself.

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Joe Magyer

Joe Magyer is the advisor of Motley Fool Inside Value and Motley Fool Pro AU. A professional Fool since 2007, he now resides in Sydney, Australia. You can follow Joe on Twitter at @Magyer.

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