3 More Value Traps to Avoid Right Now

Back in April, we talked about how history's greatest investor, Berkshire Hathaway's (NYSE: BRK-B  ) 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. Picture oil refiners like Valero Energy, chemical producers like Dow Chemical (Nasdaq: DOW  ) , etc. Kind of like being the rope in a tug o' war.

I learned this lesson the hard way with Valero when I recommended it 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 took the company public in the summer of 2007 so that you could join in their successes?

But what about, say, Chipotle (NYSE: CMG  ) , Baidu (Nasdaq: BIDU  ) , or Visa  (NYSE: V  ) ? Sure, they're shining examples of semi-recent IPO success, but they're also cherry-picked exceptions of greatness. For each of those huge wins, there's a host of huge losers like Palm (Nasdaq: PALM  ) and Pets.com. 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 as Netflix 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. Monsanto is the 800-lb. gorilla of the world seed market, dominating competitors like DuPont (NYSE: DD  ) 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 7 percentage points per recommendation since its inception in 2004.

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 November. 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.

This article was first published December 4, 2009. It has been updated.

Senior analyst Joe Magyer has no financial interest in any of the companies mentioned in this article. You can email him here. Monsanto is an Inside Value recommendation. Netflix is a Stock Advisor recommendation. Baidu and Chipotle are Rule Breakers recommendations. Berkshire Hathaway is both a Stock Advisor and Inside Value pick. The Motley Fool owns shares of Chipotle and Berkshire. The Motley Fool has a disclosure policy.


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