3 More Value Traps to Avoid Right Now

Back in April, we talked about how history's greatest investor, Warren Buffett, has two simple rules.

  • Rule No. 1: Never lose money.
  • Rule No. 2: Never forget rule No. 1.

Another big, sarcastic thank-you, Warren!
Sounds great on paper, and that mind-set certainly helped Buffett on his path to billions. Practically speaking, though, the only way for us to be absolutely sure we won't lose money is to stuff it under our mattresses.

Assuming we're investing, however, we can avoid losing money by avoiding value traps. They're the stocks that look cheap -- and stay that way. Value traps are investing quicksand, and stepping in them is the surest way to leave your portfolio mired in the mud.

3 more value traps to avoid right now
I told you back then about five value traps to avoid -- the Quarter-Life Crisis, the Too-High Yielder, etc. But having spent a few more months digesting our recession, watching industries shake out, and debating with fellow Fools until they turn the lights on at our favorite local pub, I've defined three more value traps that we should all avoid.

1. The Middleman
Middlemen are frequently price-takers on both ends, meaning they've little clout with either their suppliers or their customers. The Middleman is just along for the ride, which is usually a bumpy one given their weak bargaining power. Picture low margins, high capital needs, over-capacity, and profits that swing wildly, usually at the whim of outside forces. Kind of like being the rope in a tug o' war.

I learned this lesson the hard way, recommending oil refiner Valero Energy (NYSE: VLO  ) to Fool readers in June of 2008. I predicted (correctly) that oil prices were due for a fall, but was wrong that lower gasoline prices would spur demand. Turns out that gasoline volumes fell in lockstep, dragging profits -- and Valero's shares -- down with them.

2. The IPO
Companies usually go public for one over-arching reason: Their investors want to cash in some chips, and they've found just the right time (and price) at which to do it. They think they've found a patsy -- you. Really, did you think the financial whizzes at Blackstone (NYSE: BX  ) took the company public in the summer of 2007 so that you could join in their successes?

But what about, say, a Google (Nasdaq: GOOG  ) or Microsoft (Nasdaq: MSFT  ) ? Sure, they're both shining examples of IPO success, but they're also cherry-picked exceptions of greatness. Robust empirical research on five-year returns of IPOs from the years 1970 through 2000 found that they consistently underperformed the market after their first day of trading.

3. The Rule Taker
This might be the most poisonous value trap of them all. They don't have the power to make or break rules -- just take them. The Rule Taker is a company whose business is standing on the tracks as a technological freight train is about to pull through. Save for a Hail Mary or two, Rule Takers are out of options. Picture newspapers getting bowled over by the Internet, or the poor souls who bought into Blockbuster (NYSE: BBI  ) as Netflix (Nasdaq: NFLX  ) and the new age of digital content distribution took off.

Owning shares of these declining businesses is playing with investing fire. Sure, you might luck out with a turnaround or a dead-cat bounce, but failure is practically inevitable.

Better know a trap! 
Remember: In addition to avoiding the original five value traps, you can dramatically improve your long-run performance by:

  1. Avoiding middlemen businesses that are two-way price-takers.
  2. Staying away from the IPO hype.
  3. Shunning declining, rule-taking businesses no matter what their price.

The Anti-Trap
Now consider one of our recent recommendations at the Fool's value-focused premium service, Inside Value: Monsanto (NYSE: MON  ) . Monsanto is the 800-lb. gorilla of the world seed market, dominating competitors with its line-up of high-tech, high-yielding seeds that allow farmers to get a huge bang for their buck.

Monsanto is a darling compared to our traps. Unlike the Middleman, Monsanto has strong pricing power, consistent cash generation, and earns huge returns on invested capital.

Unlike most freshly IPO'd businesses, Monsanto is a proven business that has produced market-thumping returns over the past several years. And with Monsanto CEO and Chairman Hugh Grant owning more than half a million shares of Monsanto, you can be darn sure he's working on shareholders' behalf.

Oh, and Rule-Taking? Consider this: Not only is Monsanto the global leader in seed sales, but most of Monsanto's competitors actually license its intellectual property for their seeds. Monsanto doesn't take the rules -- it makes them.

Two for the price of one
Monsanto isn't your run-of-the-mill value stock, but that's the way Philip Durell and I like it at Inside Value. Knowing that value comes in all shapes and sizes has been a secret to the product's success over the years, helping Inside Value to beat the market by more than 5 percentage points per recommendation since its inception in 2004. That and doing our best to steer clear of value traps, of course.

New subscribers receive a new value report each month, access to all of our previous recommendations, and monthly updates on our top stocks for new money. New members also receive a free copy of the Fool's flagship special report, Stocks 2010, featuring 10 buy recommendations from the Fool's top advisors and analysts. Last year's report beat the market by an average of more than 47 percentage points through the start of last month. If you'd like to see what we're recommending now, click here for a free, 30-day trial. There's no obligation to subscribe.

Senior analyst Joe Magyer has no financial interest in any of the companies mentioned in this article. You can email him here. Google is a Motley Fool Rule Breakers recommendation, while Monsanto and Microsoft are Inside Value recommendations. Netflix is a Stock Advisor recommendation. Motley Fool Options has recommended a diagonal call on Microsoft. The Motley Fool has a disclosure policy.


Read/Post Comments (24) | Recommend This Article (49)

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 December 04, 2009, at 4:46 PM, funfundvierzig wrote:

    DuPont's customarily evasive Management finally got around today, Dec. 4, 2009, to admitting their troubled seed trait, Optimum®GAP® parodically, won't be on shelves commercially for farmers until the middle of the next decade at the earliest. That's confirmation DuPont's ponderous Pioneer seed unit will be licensing Monsanto's superior seed traits for their own otherwise ordinary line-up for years to come. ...funfun..

  • Report this Comment On December 04, 2009, at 6:24 PM, jsdick19 wrote:

    Monsanto is the leading corrupter of our food supply with their introduction of noxious GMO products. These people should be in jail. If you want to profit from the activities of these miscreants go ahead.

  • Report this Comment On December 04, 2009, at 7:02 PM, eekthecat wrote:

    Monsanto drives competition out of the market by throwing their endless money supply into merit-less lawsuits that the defendants can't afford to defend against. They bully farmers in court into using their products. They also manufactured Agent Orange and DDT. How can anyone in good conscience invest in such a company?

  • Report this Comment On December 04, 2009, at 7:54 PM, jerryc3 wrote:

    Monsanto is the mother of all that is evil. any investment in them would mean checking all your morality at the door. greed and greed alone would be the only reason.

  • Report this Comment On December 04, 2009, at 7:59 PM, michaelaknight wrote:

    said it before and I'll say it again, Monsanto is just plain wrong. Why The Fool continues to push this disease is beyond me... MON breaks every ethical rule of The Fool, and yet somehow they get mentioned ad naseum in even the subscription sections of TMF. Shame on you.

  • Report this Comment On December 04, 2009, at 8:54 PM, TMFJoeInvestor wrote:

    Folks,

    Thanks for the feedback. Your comments about my recommendation remind me of this classic exchange between Oprah and butter queen Paula Deen:

    Oprah: So what do you say to your health-conscious critics?

    Paula: I'm your cook, not your doctor.

    I'm a stock picker looking to deliver winning investments ideas. I'm not your Dad, spiritual advisor, or life coach. To each their own with their comfort zones, but I hope you were still able to take away some of what I see in Monsanto and relate that to other ideas you come across that better fit your goals.

    Best,

    Joe

  • Report this Comment On December 04, 2009, at 9:10 PM, TMFJoeInvestor wrote:

    Folks,

    Thanks for the feedback. Your comments about my recommendation remind me of this classic exchange between Oprah and butter queen Paula Deen:

    Oprah: So what do you say to your health-conscious critics?

    Paula: I'm your cook, not your doctor.

    I'm a stock picker looking to deliver winning investments ideas, not your spiritual advisor or life coach. Not all of our analysts and advisors take such a viewpoint, but that's where I come down. To each their own with their comfort zones.

    In any case, I hope you were still able to take away some of the positive business dynamcis I see in Monsanto and relate them to other ideas you come across that better fit your goals.

    Best,

    Joe

  • Report this Comment On December 05, 2009, at 7:52 AM, Shawnerz wrote:

    MON? I don't know, Joe. I know there's more than P/E, but it's around 21. Amount of cash is slightly more than debt. EBITA is mediocre.

    Don't get me wrong, I don't think anyone has to worry about MON going anywhere soon, but I'm not seeing stellar financials.

    MON has been on my watch list since March. I thought the DuPont legal action or fallout from the Schmiser lawsuit might lower prices. But they haven't. IMHO, at this point, it's still overvalued.

    -Shawn

  • Report this Comment On December 05, 2009, at 10:35 AM, defendourcountry wrote:

    Monsanto... I have been looking at this company since I was a kid, used one of his chemicals but I will not buy the stock; lets call it a moral issue. We are all here to make money and have fun, life is short so make the most of it though at what cost...

    I will recomend to watch the movie "The Future of Food"

    Folks scary future awaits us.

  • Report this Comment On December 05, 2009, at 11:04 AM, funfundvierzig wrote:

    Joe Mayger and Foolish Readers,

    Remember Monsanto Chief Hugh Grant's published letter of Aug. 17, 2009 to DuPont Chairman Chad Holliday calling for an investigation by DuPont's independent Directors into DuPont's systematic campaign of "dirty tricks" to defame Monsanto's business? Grant adverted to DuPont's deployment of and covert bankrolling of "masked" third-party operatives to smear Monsanto.

    Query, are some of the hostile hecklers on this thread shilling for DuPont Management?

    ...funfun..

  • Report this Comment On December 05, 2009, at 12:57 PM, MORK000 wrote:

    IT'S BAD ENOUGH THAT THEY TAKE MY MONEY BUT PLOEASE DON'T MESS WITH MY FOOD!

  • Report this Comment On December 05, 2009, at 1:03 PM, heidi115 wrote:

    mon is a good stock through the years. none of us are without sin. keep fooling

  • Report this Comment On December 05, 2009, at 2:20 PM, AnnefromBelgium wrote:

    sight. Indeed. Sometimes I wish shareholding would respect also at least SOME ethical values. What Monsanto does with its seeds - the food of the world - is a disgrace... (and I think it may well be even more disturbing than shares from the Tobacco industry and pharma etc). I do deeply respect the fool's 'rebel' attitude so I would wish it would also apply to this field.

  • Report this Comment On December 06, 2009, at 12:49 PM, johnhenr wrote:

    What is it with all these anti-Monsanto threads? I'm here to make money and get advice on how to best achieve that goal. Enough with the moralizing and anti-business lectures.

  • Report this Comment On December 06, 2009, at 12:49 PM, johnhenr wrote:

    What is it with all these anti-Monsanto threads? I'm here to make money and get advice on how to best achieve that goal. Enough with the moralizing and anti-business lectures.

  • Report this Comment On December 06, 2009, at 1:40 PM, modeltim wrote:

    Dear Joe,

    Your disclaimers taken aside, I really wish there was an ethical line that MF would draw in the sand when it comes to how low you are willing to sink in "objectively" evaluating such corporate evil doers.

  • Report this Comment On December 06, 2009, at 5:51 PM, jlanganki wrote:

    Unless I'm missing something I don't see anything that makes Monsanto look like a bargain. It may be an okay stock to own, but I wouldn't buy it based on its current valuation.

  • Report this Comment On December 07, 2009, at 12:10 AM, pussygato wrote:

    The scientists and exucutives at monsato have saved thousounds, maybe millions of children from slow horrible beaths from starvation. You "liberal" religious fanatics who think it would have been good for those children to die a 'natural death' should do some research.

    Sarart by googling Norman Baroug. He and his team

    helped humanity more than anyone else in history. The liberals hating him!!

  • Report this Comment On December 07, 2009, at 11:59 AM, MrSucrose wrote:

    Ah, Monsanto was my greatest stock of all time. I bought in at around $6 and held on for the ride up to $115. 19 bagger - Brings a tear to my eye.

    Learned the big lesson that is better to be generally right than percisely wrong as I didn't understand all the pricing power that the company exerted. I just had a feeling that the company was sitting on a megatrend.

  • Report this Comment On December 07, 2009, at 12:08 PM, mhonarvar wrote:

    Saying "im just a stock picker...im not your ethical advisor"....is no different than what Nazi soldiers said after the war..."I was just doing what I was told".

  • Report this Comment On December 07, 2009, at 12:33 PM, ejhejh wrote:

    ejh7454

    I recently discovered that my subscription to the Fools had been renewed without my knowledge or permission. Ethical? Good business? You decide, but think about it before you give them your credit card number....

  • Report this Comment On December 07, 2009, at 1:38 PM, trost wrote:

    Well, as many antimons out there...maybe it isn't the greatest to invest in especially if these antimon threads are anything close to a correlation to the rest of the world out there. Will the sentiments that the antimons have lead the world not to buy products with mon's genetic traits, modified genetics or chemical compounds? If these threads are any indication, demand will eventually lower for this giant, they will fall behind the supply/demand power curve until they ....become green? the mon saga continues, how will the world react? Should the Fool take heed? Or will the food supply be greatly enhanced by mon and lead us to a new world order with food for all and peace through out the world….Mon – Angle or Demon?

    Always a rabbit!

    MDT

  • Report this Comment On December 09, 2009, at 12:59 PM, ejazz2095 wrote:

    Monsanto = Satan incarnate

  • Report this Comment On December 10, 2009, at 3:13 PM, timisme16 wrote:

    I think there is a very important note to be made about Valero, and middlemen in general. You touched on it a bit, but I think it should clearer. The thing that makes Valero such a hazard is that gasoline is gasoline, no matter who you buy it from. There is no way for Valero to differentiate its product from any other refiner out there. Being a middleman in and of itself is not necessarily a bad thing, having no control over the price at which you can sell your products is.

    Many other companies are susceptible to increases in prices of the inputs they use, but most can pass on, at least in part, these increases to their customers. Valero can't do this.

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