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Don't Be Fooled by These "Value Stocks"

By Timothy Green – Updated Apr 17, 2019 at 2:45PM

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Focusing on valuation alone will get you into trouble.

Value investing is more complicated than simply buying stocks with low price-to-earnings ratios. A stock that looks cheap is often cheap for a reason, and that reason often disqualifies it as a reasonable investment. The value of any stock is based on the future, not the past. That's true no matter if you're a story-driven growth investor or a fundamentals-driven value investor.

I don't think it's a stretch to say that many stocks touted as "value stocks" are anything but. It can be tempting to focus on the cheap valuation while ignoring the long-term story, but that's a recipe for disaster. In rare cases, a beaten-down valuation is paired with solid long-term growth prospects. That's the kind of value stock you want to buy.

What kind of "value stock" should you avoid? Video game retailer GameStop (GME 9.06%) and PC and printer giant HP (HPQ 2.09%) are two prime examples.

A man holding his head looking at declining charts.

Image source: Getty Images.

Dead in the water

GameStop operates thousands of stores that sell game consoles and physical game discs. It makes a lot of money buying and selling used versions of the game discs. The used-games business is its cash cow.

Game consoles probably aren't going away, but physical discs will eventually. Downloads are already eating into GameStop's business, and the eventual proliferation of game subscription services and maybe even game streaming services will be the final nail in the coffin. Microsoft is reportedly planning a version of its Xbox One game console with no disc drive, and Alphabet's Google will soon launch its Stadia game streaming service.

There's no such thing as a used digital game. That presents what is likely to be an insurmountable problem for GameStop. Its core business is just about guaranteed to vanish as game consoles continue their shift toward digital.

GameStop expects to report adjusted earnings per share as high as $2.75 for fiscal 2018. That puts the price-to-earnings ratio at less than 4. But I wouldn't touch this stock with a 10-foot pole, because those earnings are unsustainable. Ten years from now, how much will GameStop be earning? Will GameStop even exist?

GameStop stock has looked cheap for a long time, but that hasn't stopped it from losing more than 75% of its value over the past five years. Looking cheap and being cheap are not the same thing.

Check out the latest earnings call transcripts for GameStop and HP.

Ripe for disruption

HP sells PCs and printers. Most of its revenue comes from the low-margin PC business, but most of its profit comes from printing, specifically the high-margin business of selling printing supplies like ink and toner. HP uses a razor-and-blade model, selling inexpensive hardware paired with expensive supplies. That strategy has been highly lucrative for the company.

But HPs cash cow appears to be in the process of being disrupted. The company was caught off guard by a 3% decline in printing-supply sales during its fiscal first quarter. That may not seem like a big deal, but it's the reason behind the decline that's the problem.

HP CEO Dion Weisler explained that the growth of e-commerce has allowed aftermarket manufacturers to step up their game, investing in better technology faster than in the past. Customers have also become more price sensitive, an issue for a company that relies on inflated prices for much of its profits.

HP loses badly to aftermarket sources of printing supplies on price. That pricing discrepancy now appears to be catching up with the company. Consumers and businesses are increasingly turning online to buy supplies, where HP has a lower market share compared to traditional channels.

HP expects to produce around $2.17 in per-share earnings this year, good for a price-to-earnings ratio of just 9. But future earnings depend on a status quo that may be in the early stages of unraveling. Will HP continue to be able to charge crazy-high prices for printer ink and toner indefinitely? I doubt it. Razor-and-blades business models work until they don't.

The situation that HP finds itself in is nowhere near as dire as GameStop's predicament. But the potential for a slow erosion of the ultra-high-margin business that powers HP's earnings is enough to stay away from the stock.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Timothy Green has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Microsoft. The Motley Fool owns shares of GameStop and has the following options: short April 2019 $13 calls on GameStop. The Motley Fool has a disclosure policy.

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Stocks Mentioned

HP Inc. Stock Quote
HP Inc.
HPQ
$26.43 (2.09%) $0.54
GameStop Corp. Stock Quote
GameStop Corp.
GME
$27.68 (9.06%) $2.30

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