It's hard to make a case against value investing, where you strive to buy stocks at a big discount to their actual worth. Such investments are presumed more likely to go up than down, as they have a built-in margin of safety. So what could go wrong? Well, a few things.
For one thing, we often make value investing seem easier than it really is. For example, we might simply seek out companies with low price-to-earnings ratios. A low P/E can indeed flag an undervalued stock and a prime value-investing candidate, but sometimes the P/E is low for good reason. You do want to focus on stocks with seemingly low prices, but you also want the companies behind the stocks to be brimming with potential, even if they're facing some temporary challenges.
Thus you should dig in to learn as much as you can, rather than simply relying on a few promising numbers. Below are three stocks that a value-investing screen turned up. A closer look reveals not only why each is appealing, but also why investors should think twice before jumping in.
Cliffs Natural Resources (NYSE: CLF )
Mining specialist Cliffs has been struggling with an oversupplied iron ore market, where low prices and relatively high costs have caused grief. (Cliffs also produces metallurgical coal, used in steelmaking.) There are reasons to be both hopeful and worried about Cliffs. On the plus side, met-coal production in North America is falling, which could prop up prices, and the company is working on cutting costs. Demand is likely to grow over time, too, as global economies continue recovering, and the company is generating free cash flow. With a forward-looking P/E ratio near 14, an investor focused on value investing is likely to be interested in Cliffs.
On the other hand, the company carries a lot of debt, and it's sitting on a lot of inventory due to lower-than-expected sales. In its last quarter, Cliffs posted a much wider-than-expected loss, and analysts at Morgan Stanley cited concerns about growing competition and depleting assets in Australia. The company blamed the harsh winter for some of its troubles and noted "strong demand" in North America. Meanwhile, the Casablanca Capital hedge fund is waging a proxy battle to split the company in two. Cliffs does sport a 3.4% dividend yield, but it's not a stranger to dividend cuts. Should you buy Cliffs? Well, although you can collect a dividend while you wait for the stock to reach its full potential, you might find more compelling candidates in the value investing universe.
Coach (NYSE: COH )
Coach has been a luxury fashion brand for a long time, and has rewarded longtime shareholders. Those who have owned the stock over the last year or two haven't fared as well, though, with shares near a 52-week low. Fashion is a fickle affair, after all, and Coach faces able competition, such as from Michael Kors. Coach's last quarter featured revenue down about 7% over year-ago levels, and net income down 20%. Worse still, North American revenue plunged 18%. What's going on? Well, the company's costs are rising, and it has introduced a new line of offerings, shifting its brand identity away from classic and toward luxury.
You needn't write Coach off completely, though. Dig deeper, and you might find yourself a long-term believer. Value-investing bulls like the company's recent strong growth in China and Japan, for example, and men's apparel has been selling well. Its P/E ratio near 13 is appealing, too, and the stock offers a 3.2% dividend yield for those who wait. If you're well versed in the retail landscape and have faith in the staying power and long-term value of the Coach brand, some shares of this stock may fit well in your value investing portfolio.
Petroleo Brasileiro Petrobras SA (NYSE: PBR )
Commonly known as Petrobras, Brazil's oil giant (majority-owned by the Brazilian government), is another candidate for a portfolio focused on value investing. With a forward P/E ratio near seven, the stock seems quite appealing. It also reflects a company that has been beaten down by charges of mismanagement and bribery, as well as concerns over production delays and a massive debt load. Petrobras has also had to deal with governmental meddling in its business -- for example, when gas prices are kept below production costs. As a Reuters report noted, "Petrobras has the highest debt levels and lowest profitability of any major oil company." On the other hand, though, it's investing heavily in projects that can fuel growth -- and has even been adding to its debt in order to do so. Its offshore developments are promising, and the company is aggressively aiming to double production capacity by the end of the decade. In recent news, Petrobras reported record production in its presalt fields in the Campos basin. The stock is cheap, but it also has a more uncertain future than other stocks you can find in the value investing universe. Consider whether its potential rewards seem worth the risk.
Value investing has made a lot of people rich, but you shouldn't make the mistake of thinking it's simple. Find stocks with compelling prices, but then make sure there's a solid investment thesis for them, too. Take comfort in the margin of safety, but be on the lookout for signs of trouble. And if that seems like too much work, consider a simple, low-cost index fund.
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