3 Huge Value Traps You Must Avoid Today

If you talk to the most successful value investors on the planet these days, you'll notice a common refrain:

"We're ... finding bargains galore"
That's Whitney Tilson, whose T2 Partners has earned 7% annually since its inception in 1999 versus negative 3% for the S&P 500.

Not to be outdone, superinvestor Warren Buffett penned an op-ed in The New York Times comparing last fall to troubled periods like 1932, 1942, and the early 1980s -- all fantastic times to buy stocks.

And I never thought we would see the day when GMO's notorious perma-bear, Jeremy Grantham, would say, "You are looking at the best prices in 20 years."

The last time that guy was actually optimistic about stocks was in 1982.

Great! So, what do I buy?
Of the criteria that investors use to scope out cheap stocks, three of the most popular are:

  • Beaten-down shares.
  • Low price-to-earnings (P/E) multiples.
  • Low price-to-book value (P/B) multiples.

It makes sense -- if you can buy stocks at a discount to their former prices, to past earnings, and to the value of their assets, you've likely found a great deal.

But that's not always the case.

You knew there'd be a caveat
In a recent study, I found that the most thoroughly thrashed large caps during the last recession actually went on to underperform the least beaten-down stocks. To take one startling example, ExxonMobil (NYSE: XOM  ) remained flat during the recession and rose 75% over the next five years. EMC (NYSE: EMC  ) , on the other hand, fell 70% over that period -- and has not recovered.

How did that happen?

A 70% decline is a markdown, but not necessarily a sale, if the stock's intrinsic value has also declined -- or if it was overvalued to begin with.

That's why, in a column last September, I warned investors not to touch value traps Citigroup, Lehman Brothers, and Wachovia; many investors were (understandably) tempted by their beaten-down shares, but didn't know the extent of the carnage these firms were facing.

And just like share price histories, multiples are highly fallible metrics that can often trick investors into buying value traps.

The truth about multiples
In his most recent quarterly letter, Grantham notes that in times of severe economic distress, low multiples can signal danger. As he delicately suggests, "The cheapest price-to-book stocks are deemed by the market to have the least desirable assets. Mr. Market is not always a complete ass."

According to Grantham's proprietary data from the Great Depression, low P/E stocks "showed a massive 'value' wipeout," vastly underperforming high P/E stocks from October 1929 to June 1932.

According to my data, that has also been true of this crisis; within the S&P 500, the lowest P/E stocks like Valero (NYSE: VLO  ) underperformed stocks like Medtronic (NYSE: MDT  ) and Texas Instruments (NYSE: TXN  ) that had moderate P/Es from the start of this recession.

This isn't to say that pattern will necessarily continue, but it does confirm what many savvy Fools already know -- valuing a company means more than glancing at a multiple.

So what separates cheap stocks from value traps?
Obviously, this isn't something that can be boiled down to a single metric, but we can glean at least three warning signs from writings and interviews given by Tilson, Buffett, and Grantham:

  • Inconsistent earnings power.
  • Lots of debt.
  • Weak competitive positions.

Companies that share these characteristics are dependent on external sources of capital and can be particularly vulnerable during a credit crunch/recession double whammy such as the one we are facing today.

With that in mind, here are three stocks I believe to be value traps. While shares are beaten down, and they trade at below-market P/Es or below book value, these companies also have weak competitive positions, severely depressed earnings, and substantial debt:

Company

52-Week Return

P/E

P/B

Debt/Equity

AIG (NYSE: AIG  )

(45%)

N/A

0.1

316%

Student Loan Corp.

(47%)

18.6

0.6

1,656%

OceanFreight (Nasdaq: OCNF  )

(84%)

N/A

0.3

89%

Data from Capital IQ (a division of Standard & Poor's).

And they are facing very serious problems as well, such as acute economic headwinds, declining business, and/or managerial missteps. Future earnings may look nothing like the trailing earnings those multiples are based on, book values are in some cases illiquid or overstated, and their balance sheets appear shaky to boot.

If you want to take advantage of the opportunities this market sell-off has given us, you'll want to look elsewhere.

A better way to find value stocks
Let's contrast that with Buffett's famous purchase of $1 billion of Coca-Cola stock back in 1988.

From Roger Lowenstein's Buffett biography:

By the latter part of 1988, Coca-Cola was trading at 13 times expected 1989 earnings, or about 15% above the average stock. That was more than a Ben Graham would have paid. But given its earning power, Buffett thought he was getting a Mercedes for the price of a Chevrolet.

Given Coca-Cola's tremendous ability to generate free cash flow, a competitive brand and distribution, and potential for foreign expansion, Buffett judged the stock was trading at a discount to future cash flows. And he has been rewarded with $8.5 billion in profits for his courage.

It's companies with massive competitive advantages, huge earnings potential, and the ability to generate cash that you -- like Buffett -- want to buy.

The Foolish bottom line
Legendary value investors such as Buffett, Tilson, and Grantham all believe that stocks are cheap right now, but they're also smart to be selective about which stocks they buy. Likewise, our Motley Fool Inside Value team is astounded by the bargains we're seeing, but we know that not every stock that appears cheap necessarily is. If you'd like to see which stocks we think are real bargains today, click here to try the service free for 30 days.

Already subscribed to Inside Value? Log in at the top of this page.

This article was originally published May 29, 2009. It has been updated.

Ilan Moscovitz has no financial interest in any companies mentioned in this article. Coca-Cola is a Motley Fool Inside Value and Income Investor recommendation. The Motley Fool owns shares of and sold puts on Medtronic. The Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (7)

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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 October 07, 2009, at 12:06 PM, dracula11 wrote:

    You people all hate AIG. Iam making a bundle day trading this. Mark my word this will come roaring back and I will laugh all the way to the bank. Keep the bad comments coming on AIG. I love it.

  • Report this Comment On October 07, 2009, at 8:20 PM, lookswholaughing wrote:

    if aig waits they will come back. new ceo has right ideal. i bought aig at 2.40 a share. if i could take it back probably would but at 15000.00 invested i will just wait. if i lose it i lose it. had it to burn or i would never brought it.lets see the sept numbers.

  • Report this Comment On October 08, 2009, at 9:43 AM, ferrariedgardo wrote:

    I think your value trap for OCNF is pointed more towards the fact that they maybe issuing additional shares to buy more ships that has investors nervous.

    However, I would disagree on the fact that they are overlevered, in fact they are underlevered compared to industry standards with a D/E of around 1 and they have 100 M in cash (the market cap is 100 M right now).

    You must bare in mind that this industry is very cyclical and thus revenues go down a lot in bad times like this but in the same way they go up.

    Regarding competitive advantage I will doubt there is anything as competitive advantage in the dry bulk industry since it is a commodity and the only advantage you get is being cost efficient. In that sense OCNF is seizing the moment to buy ships at distressed prices and selling it's older ships with a lower revenue perspectives. If you do a DCF on the acquisition of those ships, you would see that by doing this OCNF is creating value by doing this move.

    I do agree that the industry is going to be a laggard until better times come, but when it comes we will see a huge rally, so my advice, you buy now, keep the shares no matter the news and wait until the rally has mulpiplied the value a few times.

  • Report this Comment On October 08, 2009, at 4:24 PM, MuscleupMiami wrote:

    In a reply to lookswholaughing: If you bought AIG at 2.40, SELL. You already made a huge profit. Greed and/or stupidity are very ugly things.

  • Report this Comment On October 15, 2009, at 4:47 PM, ndfaninsb wrote:

    I agree with ferraried Ocnf looks good long term. Steel is going up/ price of ships is going up/ trade will resume (although less ships will be going to the broke U.S.A.)/ They just bought a slightly used ship for 50 million(upgrading ships now b4 steel gets too high, smart), they have 12 ships and the total market cap right now is what 120 million or so? Do the math, thats a bargain.

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