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Don't Get Caught by These Value Traps

By Chuck Saletta - Updated Nov 11, 2016 at 4:56PM

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Just because they've dropped doesn't mean they're bargains.

As the newspapers tell us every day, the market is significantly off the highs it set in October 2007. Amid the hand-wringing, bargains the likes of which we haven't seen since Benjamin Graham's days have once again become available. Now certainly is a fantastic time to be a value investor.

But the market is down for good reason -- several good reasons, in fact.

  • The debt market is still iced over.
  • Housing is still very weak, and the Option ARM meltdown hasn't really begun.
  • Unemployment is trending upward.
  • We're officially in a recession.

And that means many stocks are down for good reason as well.

Where there's smoke
While some stocks have merely fallen victim to the overall market haircut taking place, most stocks are down because the companies they represent are genuinely struggling. Although they might be on sale, they aren't really cheap. In fact, a company's business may have deteriorated to the point where its new (and significantly lower) stock price is still too expensive relative to its actual worth.

Stocks like that are called value traps, and they can be very tempting, what with the single-digit trailing price-to-earnings ratios we're seeing all over the place these days. But if there's a good reason why shares are available at such a "low" price, you probably want to stay away.

For instance, these well-known firms are all trading significantly off their 52-week highs, all with low P/E ratios -- and all of them have good reason to be selling so "cheaply."

Company

Trailing Normalized PE Ratio

Fall From 52- Week High

Key Risk Factors

Marriott (NYSE:MAR)

10.1

(60.4%)

Dependent on business travel in a weak economy.

New York Times (NYSE:NYT)

8.24

(67.0%)

Shift to online news sources with fewer barriers to entry.

Honeywell (NYSE:HON)

7.0

(58.7%)

Defense contractor near an expected reduction of active missions.

Rio Tinto (NYSE:RTP)

2.3

(85.5%)

Mining company during a commodity slump.

Coca-Cola Enterprises (NYSE:CCE)

9.2

(66.8%)

Debt-heavy business amid a global capital crunch.

Boeing (NYSE:BA)

7.8

(57.4%)

Labor trouble, significant delay on flagship product, did not win key military contracts.

Although most, if not all, of these companies will likely survive this current economic mess, that won't necessarily protect their shareholders. I doubt, for instance, that Coca-Cola (NYSE:KO) would let its bottler completely fail. Likewise, aerospace and defense giant Boeing probably falls into the "too [blank] to fail" category, even if airlines remain weak and it continues to struggle to deliver the 787 Dreamliner.

But as shareholders in AIG are painfully aware, there's nothing preventing either company from diluting its shares -- sometimes to an extreme -- if they need to raise capital.

Find real value
It can be tough to tell the difference between a company that's legitimately value priced and one that's a trap waiting to ensnare your cash. Although there are many wonderful opportunities out there right now, there are at least as many stocks that deserve their haircuts.

In order to stay out of the traps, you need to look beyond the top-line metrics of PE ratios and percent off highs, and study the deeper financials and more qualitative measures. These days, the companies that not only look cheap, but are also most likely to be legitimately value-priced, are ones that:

  • Operate in "must have" lines of business,
  • Have very clean balance sheets,
  • Don't require continuous capital injections themselves, and
  • Have customers that can afford their products without debt financing.

So don't settle for the easy metrics -- dig deep to figure out why the company's share price has dropped so dramatically. If you can't find a reason -- and if this new, lower, price represents a real discount to its intrinsic value -- then, and only then, consider adding it to your portfolio.

The Foolish bottom line
There are a lot of bargains out there waiting to be snatched up -- but there are just as many value traps waiting to ensnare you. Learning to tell the difference -- not just in this market, but in every market -- can help you build a robust portfolio for the long term.

At Motley Fool Inside Value, we're thrilled to be finding excellent companies on the cheap, since the market continues to throw the good ones out with the real stinkers. If you're ready to invest in the companies most likely to emerge stronger once this mess subsides, join us today. A free 30-day trial lets you see which companies we're recommending as tremendous bargains. Just click here to get started. There's no obligation to subscribe.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta did not own shares of any company mentioned in this article. Coca-Cola is a Motley Fool Inside Value selection. The Fool has a disclosure policy.

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Stocks Mentioned

The Coca-Cola Company Stock Quote
The Coca-Cola Company
KO
$63.70 (0.76%) $0.48
The Boeing Company Stock Quote
The Boeing Company
BA
$169.99 (1.26%) $2.11
Honeywell International Inc. Stock Quote
Honeywell International Inc.
HON
$200.87 (1.19%) $2.36
Marriott International, Inc. Stock Quote
Marriott International, Inc.
MAR
$164.07 (1.82%) $2.94
The New York Times Company Stock Quote
The New York Times Company
NYT
$33.74 (-3.74%) $-1.31

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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