The High Price of Cheap Stocks

RadioShack's shares looked cheap right up until they weren't. Should investors dumpster dive for RadioShack or invest in quality like Wal-Mart?

Jul 17, 2014 at 1:00PM

RadioShack (NYSE:RSHCQ) got its start as a nerd's paradise. Every kind of cable, widget, tube, model or gadget you wanted, they had it. Here we are in 2014, and many of the world's most successful companies are tech companies like Facebook and Google -- nerds rule. But what about RadioShack?

Amid the tech ascendancy, RadioShack has cratered.When your customers are tech-savvy nerds (I mean that as a compliment by the way), they are even more likely to buy online. That spells trouble for RadioShack.

Beyond the qualitative factors that govern the success and failure of business models, there is another lesson for investors on the quantitative side -- metrics that imply cheap prices can mislead. Compared to the S&P 500's P/E ratio, RadioShack's P/E has looked like a bargain. Who doesn't like buying dollar bills for $0.50?

Unfortunately for RadioShack shareholders, they may have paid $0.50 but they did not get back a dollar bill -- instead they may have bought a quarter's worth of value. Have a look at the relationship between RadioShack's P/E ratio versus its price.

RSH Chart

RSH data by YCharts

Here is a stock that looked cheap as can be -- a single digit P/E is cigar-butt territory. It looked cheap right up until its earnings (and then price) cratered and then once that happened it looked expensive on a P/E basis. P/E is a historical metric, and driving while looking through the rear view mirror can be hazardous to your wealth. Now, RadioShack has become a distressed stock, as it has reported negative earnings since 2012. 

For an example of a more straightforward relationship between price and earnings, consider the five-year history of Wal-Mart (NYSE:WMT)

WMT Chart

WMT data by YCharts

What could have tipped off RadioShack investors that the cheap price was a facade around a failing business? 

Let's look at four metrics that all trended poorly for RadioShack. Free cash flow peaked in 2007 and steadily headed south, and it went negative in 2012. Operating margin was not high to begin with, and it peaked at 9% in 2007 and declined to negative by 2012. Earnings per share also went negative in 2012. 

RSH Free Cash Flow (TTM) Chart

RSH Free Cash Flow (TTM) data by YCharts

Was there anything to tip off investors that 2012 would turn out to be an annus horribilis for RadioShack? One line in the chart stands out. The company was unable to raise its dividend for many years before the wheels came off the wagon in 2012. A lack of a dividend raise by itself is not as big of a red flag as a dividend cut, but a lack of growth does not demonstrate that the company is a thriving business either.

By contrast, Wal-Mart has been able to deliver solid dividend growth year in and year out. The ability of a company to continually raise its dividend is an important defensive characteristic.  

WMT Chart

WMT data by YCharts

Dividend growth does not guarantee that your stock will be a high flier and generate outsized capital gains in the short run. Dividend growth does offer some downside protection by providing the ability for a company like Wal-Mart to reward its shareholders directly. A lack of dividend growth can point to worse issues cascading across a business' operations. Even if you are not investing primarily for dividends it makes sense to pay close attention to this metric to shore up your portfolio's defense. 

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Gunnar Peterson owns shares of Facebook and Google (C shares). The Motley Fool recommends Facebook and Google (C shares). The Motley Fool owns shares of Facebook and Google (C shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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