History's greatest investor, Warren Buffett, has two simple rules.

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

A big, sarcastic thank-you, Warren! 
Sure, practically everyone has lost money in this market -- including Buffett. But take it easy on the Oracle here, because he's dead-on. Buffett's intense focus on not just investing in great opportunities, but also avoiding terrible ones, has been the key to his epic success.

Avoiding soul-sucking investments -- what we investing nerds dub "value traps" -- is hardly rocket science. Yet, incredibly, I see investors, new and salty alike, make the same mistakes over and over again, breaking Buffett's rules and walking right into what seem like obvious value traps.

Having spent way too much time thinking about it, I've concluded that there are five primary categories of these dreaded mistakes. Avoiding these five traps will save you time, money, and more than a little heartache.

1. The quarter-life crisis 
These are real heartbreakers. You find a dominant company whose once-sky-high growth has stalled, and its shares along with it. "TechWidget Corp. is trading at only 15 times earnings right now, only half its five-year average!" you say. "Its earnings have doubled over the past five years, but the shares are down over the same time period. Sounds like a steal!"

Snap! You just walked into a value trap.

Investors falsely believe that names like Dell and Yahoo! will go back to the relative valuations of their headier days. They won't. Why? For starters, growth has slowed, technology evolved, and competition emerged. But all of that misses the real reason.

Instead of returning incremental profits to shareholders via dividends, such companies wreck shareholder value by chasing growth through non-core expansion and high-profile acquisitions. Oh, and the ill-timed share repurchases that exist primarily to juice per-share earnings and help sop up all that stock option-driven dilution.

Steer clear of flailing high-tech titans until they're ready, willing, and able to follow the lead of an Oracle or Qualcomm into dividend-paying adulthood.

2. The soaring cyclical 
Here's the thing about cyclical stocks: Their P/E ratios are counterintuitive. They always look the cheapest when they've reached their priciest, and look priciest when they've reached their cheapest.

Take nearly any oil play from the summer of 2008 as an example. Apache (NYSE: APA), Halliburton (NYSE: HAL), and Suncor (NYSE: SU) looked cheap via a crude, PEG-style valuation. But savvy investors know that cyclical companies' profits mean-revert, which is why cyclical stocks' P/E multiples stay low during booms and high during busts. In other words, you should be looking at cyclical stocks as their P/Es expand, not shrink.

3. The small-cap Methuselah 
The six-year small-cap bull run that came crashing to a halt in 2008 was a painful reminder of a little-known value trap: the small-cap Methuselah.

Century-old small caps you'd never heard of were wrapping up five-year runs of 20% annualized earnings growth. Analysts went gaga, extrapolating those growth rates forward like the party would never end. Valuations followed suit. Gaga analyst, meet mean-reversion.

You won't find many long-run compounding machines in the small-cap space. Show me a company with a long, proven history of creating serious shareholder value, and I'll show you a mid- or large-cap stock.

4. The too-high yielder 
A company usually has a high yield (think above 7%) for one of three reasons:

  • It has limited growth potential, so managers return as much cash as they can to shareholders. Think regional telecoms.
  • The company is in a clear state of decline and investors expect a dividend cut. Think terrestrial radio or newspapers.
  • The company is in a tax-advantaged structure that doesn't allow it to retain much capital. Think business development companies, real estate investment trusts, or master limited partnerships like Enterprise Products Partners (NYSE: EPD) or Kinder Morgan Energy Partners (NYSE: KMP).

Broadly speaking, a fat dividend is a good thing. There's a fine line, though. At Motley Fool Income Investor, we're looking for that sweet spot where an attractive payout meets rest-easy status.

Take Income Investor recommendation Automatic Data Processing (NYSE: ADP). The top dog of the payroll processing business rakes in profits, turning about 17% of revenues into free cash flow. It acts like a tollbooth, collecting fees for each check that passes through its system. Even better, it also collects interest on the payroll funds that it temporarily holds for clients. Between the tollbooth fee structure, the gravy that is the interest income, and the stickiness of the customer base (the average client has been with ADP for over a decade), you're talking about a remarkably powerful business model capable of spinning off fat dividends for decades. The Income Investor team pegs the shares as having 18% upside, with a 3.2% yield to boot.

ADP: A low-risk stock with solid upside and a fat dividend yield. That's low-hanging fruit for the income-loving investor.

5. The unopened book 
Book values need to be adjusted -- especially heading into and during recessions. Acquisition-happy companies inevitably end up slashing the goodwill they'd booked while making bloated acquisitions in the years previous. Witness IAC (Nasdaq: IACI), which last year wrote down $1 billion worth of goodwill and intangible assets in its Search & Media segment.

The book values of asset-centric plays (homebuilders, natural resource producers, etc.) also need a good tweaking to reflect the depressed values of those assets.

Don't get me wrong: I'm all for buying stocks when they're down and out. We do just that at Income Investor. But there's a catch: We're only interested in good values if they also happen to be great businesses, companies with years of exceptional performance behind and ahead of them. And, of course, ones that pay us to wait for our thesis to play out.

But I digress.

Wrapping the traps 
To recap, you can smooth and improve your returns if you:

  1. Avoid the stalled-out growth stock undergoing a quarter-life crisis.
  2. Don't get tripped up by seemingly cheap soaring cyclicals.
  3. Steer clear of hot small caps with blah track records.
  4. Think twice about the yield that looks too good to be true.
  5. Don't lean on inflated or unadjusted book values.

You've probably picked up on an underlying theme here: You need unconventionally conventional thinking if you want low-stress success in the stock market.

Looking for great, simple-to-understand businesses at good prices is the easiest way to avoid stepping into a value trap -- and bag great returns besides. That's what advisor James Early and friends do over at Income Investor, where our average recommendation yields 4.3% and has beaten the market by seven percentage points. Just click here to get started.

This article was first published April 24, 2009. It has been updated.

Senior analyst Joe Magyer owns shares of Automatic Data Processing, which is an Income Investor recommendation. Enterprise Products is also an Income Investor recommendation. The Fool owns shares of Oracle. The Motley Fool's disclosure policy lives vicariously through itself.