Investing in the stock market is all about finding a good value. This doesn't mean a stock needs to have an exceptionally low share price or P/E ratio to be a good value if the long-term growth prospects for a business look strong. But when in doubt, seeking out stocks that exhibit fundamentally attractive ratios relative to their peers can sometimes be a great indication of an undervalued investment opportunity.
Sometimes, however, it could mean something entirely different.
Value trap alert!
In some instances, stocks trading at a substantial discount to their peers may actually be what's known as a value trap. A value trap is a beaten-down company that might appear to be valued extremely cheap on the surface, but underlying problems in the business model could continue pressuring its performance. Investors commonly mistake value traps for value stocks, then get caught scratching their heads as their investments move lower.
The good news -- if there is any good news of being caught in a value trap -- is that it's happened to the best of us. I know I've fallen for what I believed was a great value, only to have ignored some glaring warning sign within a stock or sector, and many great investors have done the same both before and after me. Investing is a learning process, and the greatest gift you can give is to pass along what you've learned to others so they (hopefully) don't make the same mistake.
Today, we're going to take a look at a few stocks that I believe are blatant value traps. As always, these are mere suggestions on my part, and you should take my suggestion to distance your money from these stocks merely as an impetus to begin your own research rather than as concrete advice to stay away.
PDL BioPharma (NASDAQ:PDLI)
PDL BioPharma might be the most perfect example I can offer of a value trap. Unlike traditional biotech companies that research new therapies, test them in clinical trials, and then bring them to market, PDL BioPharma is purely a royalty company in the biotech field. PDL purchases the rights to certain patents, and then generates revenue from those patents to earn a profit. Because it doesn't run costly clinical-development programs, its overhead costs are extremely low, and it results in substantial dividend payments for investors.
As it stands at the time of this writing, PDL BioPharma is yielding nearly 13%, has a trailing P/E of 2.4 (yes, 2.4!), and is trading at a forward P/E ratio of less than six. Sounds tempting, right? In actuality, this is a big-time value trap!
PDL BioPharma's patent model and profits revolve heavily around its Queen patents. In 2014, its Queen patents accounted for $486.9 million of its $581.2 million in total sales. Just one problem: its Queen patents expired in December 2014. It'll take about 12 to 18 months to completely sell through all of the products covered by PDL's Queen patents, which is why the company is still generating substantial revenue. However, once that revenue disappears, and PDL is unable to earn substantial interest revenue, you're likely to see major drop-offs in sales, profits, and PDL's dividend.
By 2017, PDL BioPharma's annual revenue is slated to fall to just $76 million, and its profit could dip from an expected $2.17 per share in 2015 to just $0.11. That, folks, is the definition of a value trap.
A company doesn't have to be a small-cap stock, as is the case with PDL BioPharma, to be a value trap. Brazil-based Petrobras was sporting a $30 billion-plus market cap at the time of this writing, along with $1.84 in EPS in 2014. Until last year, it also regularly paid out a market-topping dividend yield, and as of its most recent quarter, boasted a whopping 16.57 billion barrels of oil equivalent in reserves.
After witnessing essentially a 90% decline in Petrobras' share price since early 2011, you might be of the opinion that its stock is now a bargain. I'm here to say, "Think again."
For starters, Petrobras is buried up to its neck in debt. The company ended its latest quarter with $107 billion in debt and just $23.6 billion in cash. Debt can sometimes be difficult for investors to properly value. While Petrobras' 16.57 billion barrels of oil equivalent in reserves does represent value, its debt may make its survival challenging if oil prices remain low for an extended period of time .
Additionally, as my Foolish colleague Matt DiLallo recently pointed out, Petrobras' cost structure can be downright terrifying. Petrobras is heavily tied to its offshore assets, and offshore assets cost considerably more to recover than onshore. It means that Petrobras' expenses are tougher to reduce than many of its onshore and diversified peers.
Even with a single-digit forward P/E, Petrobras is a possible value trap that could wind up destroying shareholder value.
Keurig Green Mountain (NASDAQ:GMCR)
Sometimes, when you spot a potential value trap you'll discover that it's a company you genuinely like. It's at those times that you must remember investing isn't an emotional process – it's all about logic and long-term investing.
Keurig Green Mountain, the company behind the single-serve beverage system that revolutionized the idea of drinking coffee at home, looks great on paper, but is in trouble if you look a bit deeper. On the surface, Keurig Green Mountain is paying out a 2% yield, trading at 15 times next year's EPS estimates, and is slated to grow by 14% per year in each of the next five years. Like I said, it sounds great.
But investors are concerned about increased competition for its hot-beverage systems following the disappointing sales of its next-generation Keurig 2.0, and the potential for missteps when introducing its Keurig Kold system for cold beverages. The Keurig Kold, which was introduced at a whopping $369 price and comes with a $1 cost per eight-ounce beverage, may receive an equally cold reception from consumers who are looking as if they'll be cost conscious this holiday season.
The partial good news for Keurig Green Mountain is that it's built a lot of partnerships throughout the years, and can use its first-in-class status to generate somewhat steady recurring hot-beverage revenue. The worry is, how will Green Mountain drive future growth? Investors have typically placed a premium on Keurig's shares because of its premier growth rate. Without that superior growth, Green Mountain may wind up seeing its shares pressured to the downside.
Value traps can be found in all sectors, so it's important that you look beyond a company's share price and P/E ratio, and examine its long-term growth prospects to get the full story behind its valuation.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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