3 Huge Value Traps You Must Avoid Today

If you talk to the most successful value investors on the planet these days, you'll notice a common refrain.

"We're ... finding bargains galore"
That's Whitney Tilson, whose T2 Partners has earned 7% annually since its inception in 1999, versus negative 3% for the S&P 500.

Not to be outdone, superinvestor Warren Buffett penned an op-ed in The New York Times comparing last fall to troubled periods like 1932, 1942, and the early 1980s -- all fantastic times to buy stocks.

And I never thought we would see the day last year when GMO's notorious perma-bear, Jeremy Grantham, said, "You are looking at the best prices in 20 years."

The last time that guy was actually optimistic about stocks was in 1982.

Great! So, what do I buy?
Of the criteria that investors use to scope out cheap stocks, three of the most popular are:

• Beaten-down shares.
• Low price-to-earnings (P/E) multiples.
• Low price-to-book value (P/B) multiples.

It makes sense -- if you can buy stocks at a discount to their former prices, to past earnings, and to the value of their assets, you've probably found a great deal.

But that's not always the case.

You knew there'd be a caveat
In a recent study, I found that the most thoroughly thrashed large caps during the last recession actually went on to underperform the least beaten-down stocks. To take one startling example, Lowe's (NYSE:LOW) rose by 28% during the recession and 69% over the next five years. Qwest (NYSE:Q), on the other hand, fell by 65% -- and has not recovered.

How did that happen?

A 65% decline is a markdown, but not necessarily a sale if the stock's intrinsic value has also declined -- or if it was overvalued to begin with.

That's why, in a September 2008 column, I warned investors not to touch value traps Citigroup, Lehman Brothers, and Wachovia; many were (understandably) tempted by their beaten-down shares, but didn't know the extent of the carnage these firms were facing.

And just like share-price histories, multiples are highly fallible metrics that can often trick investors into buying value traps.

The truth about multiples
Grantham notes that in times of severe economic distress, low multiples can signal danger. As he delicately suggests: "The cheapest price-to-book stocks are deemed by the market to have the least desirable assets. Mr. Market is not always a complete ass."

According to Grantham's proprietary data from the Great Depression, low-P/E stocks "showed a massive 'value' wipeout," vastly underperforming high P/E stocks from October 1929 to June 1932.

According to my data, that's been somewhat true of this crisis as well; within the S&P 500, the lowest P/E stocks, including Dow Chemical (NYSE:DOW), underperformed stocks such as Walgreen (NYSE:WAG) and United Parcel Service (NYSE:UPS) that had moderate P/Es since the start of this recession.

This isn't to say that pattern will necessarily continue, but it does confirm what many savvy Fools already know -- valuing a company means more than glancing at a multiple.

So what separates cheap stocks from value traps?
Obviously, this isn't something that can be boiled down to a single metric, but we can glean at least three warning signs from writings and interviews from Tilson, Buffett, and Grantham:

• Inconsistent earnings power.
• Lots of debt.
• Weak competitive positions.

Companies that share these characteristics depend on external sources of capital and can be particularly vulnerable during a credit crunch/recession double-whammy, such as the one we face today.

With that in mind, here are three stocks I believe to be value traps. While shares are beaten down and trade at below-market P/Es or below book value, these companies also have weak competitive positions, severely depressed earnings, and substantial debt:

Data from Capital IQ, a division of Standard & Poor's.

And they are facing very serious problems as well, including acute economic headwinds, declining business, and/or managerial missteps. Future earnings may look nothing like the trailing earnings those multiples are based on; book values are in some cases illiquid or overstated; and their balance sheets appear shaky to boot.

If you want to take advantage of the opportunities this market sell-off has given us, you'll want to look elsewhere.

A better way to find value stocks
Let's contrast that with Buffett's famous purchase of $1 billion of Coca-Cola stock back in 1988.

From Roger Lowenstein's Buffett biography:

By the latter part of 1988, Coca-Cola was trading at 13 times expected 1989 earnings, or about 15% above the average stock. That was more than a Ben Graham would have paid. But given its earning power, Buffett thought he was getting a Mercedes for the price of a Chevrolet.

Given Coca-Cola's tremendous ability to generate free cash flow, a competitive brand and distribution, and potential for foreign expansion, Buffett judged that the stock was trading at a discount to future cash flows. And he has been rewarded with $10.5 billion in profits for his courage.

Like Buffett, you want to buy companies with massive competitive advantages, huge earnings potential, and the ability to generate cash.

The Foolish bottom line
Legendary value investors such as Buffett, Tilson, and Grantham all believe there are cheap stocks out there right now, but they're also smart to be selective about which stocks they buy. Likewise, our Motley Fool Inside Value team is astounded by the bargains we're seeing, but we know that not every stock that appears cheap necessarily is. If you'd like to see which stocks we think are real bargains today, click here to try the service free for 30 days.

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This article was originally published May 29, 2009. It has been updated.

Ilan Moscovitz has no financial interest in any companies mentioned in this article. Coca-Cola is a Motley Fool Inside Value and an Income Investor recommendation. Lowe's is also an Inside Value pick. UPS is an Income Investor selection. The Fool has a disclosure policy.