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Value investing is buying stocks that are perceived as being worth more than what you pay for them.[1] Stocks are valued most commonly by the net tangible assets of the companies they represent, earnings per share, and dividends they pay. Thus, a value investor would favor those stocks that have low price/book ratio, low price/earnings ratio, and high dividend yield.


However, it would be dangerous to go out and buy any stock that meet these criteria, as a stock that appears cheap may in fact be on the brink of bankruptcy and not a bargain at all, despite the figures. Sorting out between the true bargains and the false bargains, or value traps, is not easy. Here are some things to look for that may help you to make the distinction with caution.

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Steps

  1. Avoid Value Traps in Stocks Step 1.jpg
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    Stay clear from stocks that have dropped in price due to to exposed corporate fraud. Some recent examples like Enron, WorldCom, and Tyco have experienced marked drop in prices that make them look like bargains after their scandals were exposed, but in the end they're in a relentless trajectory to zero, leaving shareholders with nothing. Wherever fraud is involved, the figures in the financial statements that are used to determine value are meaningless, and the company simply cannot be valued appropriately. Moreover, once a fraud is discovered, the company tends to have little, if any, value left that has not already been stolen by corrupt management. Do not touch stocks of companies involved in corporate fraud with a ten foot pole!
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    Beware of overly optimistic guidance from the company's management. A company that promises to deliver smoothly increasing double digit earnings growth is unrealistic, and such promises, when they become undeliverable, may lead to fabrication of figures by the management. Warren Buffett bought huge stakes in Freddie Mac during the 1980s when the stock was truly cheap, but liquidated his position for a $2.75 billion profit during the late 1990s, after he saw signs that the overly optimistic guidance by the company's management was unachievable.[2]
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    Avoid companies with high debt or leverage. Debt or leverage is a double edged sword. In good times, you can make twice as much money using leverage and borrowing is easy; in bad times, you lose money twice as fast and the time when you need the money the most is when creditors start calling you and demanding repayment of the debt.
    • For a good margin of safety to make sure a company is able to satisfy interest payments on its debt, look for companies with at least two to four times interest coverage (earnings before interest at least two to four times interest charges). Upper limit applies to industrial issues, especially cyclical ones; lower limit applies to more stable incomes such as utilities.
    • A company with no debt is highly unlikely to go bankrupt, barring unforeseen misfortunes such as massive legal settlement against it, or inability to sell its products for more than it costs to create those products (evidenced by negative net income on the income statement). On the other hand, excessive leverage can destroy even a great company.
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    Avoid companies that have fallen due to outdated products and services. Blockbuster is a good example: who needs to go to a physical store to get videos or DVDs when they can be download at home with the click of mouse? Likewise, newspaper and physical bookstore businesses have been hurt by the expanding internet. Outdated products and services often signify that the lost revenues are probably lost forever, and that a rebound in the stock price is unlikely.
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    Be careful of companies facing increasingly stiff competition. Look at the profit margins (net earnings divided by revenue) of a company through a period of 5 to 10 years, and also compare to profit margins of competitors in its industry. If the profit margins are decreasing through the years, that usually signifies that the company is unable to pass increasing costs onto its customers due to competitive prices. If a company is no longer competitive with its competitors, better to avoid it despite the low valuations.
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    Be careful of companies in highly regulated industries. Because of high fees and regulation costs in the U.S., for example, many companies have relocated their business to other countries like China. Most consumer goods are no longer made in USA. Payday loans are another example. Making $20 in fees for every $100 loan due in 2-3 weeks is profitable. However, government caps that put the maximum interest charges to 36 percent per annum cuts this significantly.
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    Be careful of investing in stocks that have dropped due to a dividend cut, especially when the company does not expect to resume dividends any time soon. Dividend cuts usually means the company has no earnings to pay out. The price correction following a dividend cut can be prolonged. Wait till the valuations are really compelling, such as significant price drops that send the stock to 50 percent or less of its intrinsic value, before plunging in.
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    Watch out for missed earnings estimates. Analysts are generally quite lenient in their estimates and tend to revise their estimates downward before earning release to allow companies to beat their estimates and look good. Occasional missed earning estimates with over reaction in the price is a solid reason to buy on the dip, but a pattern of missing earning estimates is foreboding.
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    Invest in profitable enterprises only. Look at the company's income statements dating back at least the past five to ten years. A consistently profitable company should have at least some earnings per share for each of the past five to ten years, preferably with an upward trend. A company with consistent negative earnings every year may be too expensive at any price.
  10. Avoid Value Traps in Stocks Step 10.jpg
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    Look for insider buying. Insiders are in the best positions to know how much their company is truly worth, and if the stock price is truly cheap, they will be buying the stock. There is only one reason why insiders buy: they expect the stock to go up. If you see recent history of insider buying, it's a safe bet to follow suit. On the other hand, if you see many insiders selling, it may be an ominous sign and you should probably keep your hands off.
  11. Avoid Value Traps in Stocks Step 11.jpg
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    Check the balance sheet to make sure the company is healthy. One of the most important thing to look for that that the company should have current assets greater than current liabilities, to ensure that it can pay its bills in the short term. A more stringent test is to calculate the quick net asset by subtracting inventory (which may be illiquid) and total current liabilities from current assets. Alternatively, determine the quick current ratio by dividing (total current assets - inventory) by total current liabilities, and make sure the ratio is greater than one. Another measurement of financial health is the debt to equity ratio, obtained by dividing total liabilities by total equity plus capital surplus. Debt to equity ratio should preferably be less than 1; the lower, the better.
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Video



 This video covers a few mistakes made by first-time investors.

Tips

  • The key to avoiding value traps is to attempt to evaluate whether the drop in price is temporary or permanent. Always ask: can the company be as profitable as it has been in the past? A stock that drops due to a temporary problems, such as poor general economic conditions, increased interest rates, increased energy or raw material costs, or a one-time charge for things like a lawsuit settlement or an oil spill cleanup, will typically bounce back.
  • Look for value stocks during market recessions and depressions. When the general market is crashing due to poor economic news, it is the ideal environment for finding true value stocks. Moving averages are the most reliable in a trending market, and the MACD formula often gives timely signals. The Monthly MACD gave a sell signal January 31, 2000 and a buy signal May 31, 2003. If you had used this formula when the market was crashing, you would not have lost any money in the dot com meltdown, and would be picked up many oversold bargains, such as Apple at less than $10 between 2001 and 2003 and is now trading at over $300/share. When the general market is rising, on the other hand, hold onto your positions if the fundamentals are still sound, unless the market becomes grossly overpriced, and no stock in a good company below a price/earning ratio of 20 or a price/book ratio of 5 can be found.
  • Benjamin Graham did a study and during 100 years the Stock Market crashed 19 times and recovered (Every 5.3 years on the average). Warren Buffet (who learned from Benjamin Graham) saves cash and invests in companies that fall 4 times in price when this happens. After the 2007-2008 Subprime meltdown, Warren Buffet invested 20 billion in cash in January 2009. Every 2 years there is a smaller correction where you can buy in to smaller dips.
  • Avoid companies with overly complicated financial reports. If you cannot understand something, it's usually with good reason. Many financial advisers could not quite understand Enron's elaborate financial statements, yet they were not disinclined to recommend the stock regardless. In the end, they got burnt. Overly complicated financial reports usually signal corporate fraud exposure.
  • You may use a share value calculator to check if the intrinsic value of the stock is lower valued or over valued. Search for cheaper stocks.

Things You'll Need

  • Access to corporate financial documents
  • Financial news sources

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Sources and Citations

  1. ↑ Wisegeek, What is Value Investing?, http://www.wisegeek.com/what-is-value-investing.htm
  2. ↑ http://www.washingtonpost.com/wp-dyn/content/article/2007/10/30/AR2007103002292.html

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