Best of the Week
Most Popular
1. The Trump Stock Market Trap May Be Triggered - Barry_M_Ferguson
2.Why are Central Banks Buying Gold and Dumping Dollars? - Richard_Mills
3.US China War - Thucydides Trap and gold - Richard_Mills
4.Gold Price Trend Forcast to End September 2019 - Nadeem_Walayat
5.Money Saving Kids Gardening Growing Giant Sunflowers Summer Fun - Anika_Walayat
6.US Dollar Breakdown Begins, Gold Price to Bolt Higher - Jim_Willie_CB
7.INTEL (INTC) Stock Investing to Profit From AI Machine Learning Boom - Nadeem_Walayat
8.Will Google AI Kill Us? Man vs Machine Intelligence - N_Walayat
9.US Prepares for Currency War with China - Richard_Mills
10.Gold Price Epochal Breakout Will Not Be Negated by a Correction - Clive Maund
Last 7 days
How to Protect Your Site from Bots & Spam? - 21st Aug 19
Fed Too Late To Prevent A US Housing Market Crash? - 21st Aug 19
Gold and the Cracks in the U.S., Japan and Germany’s Economic Data - 21st Aug 19
The Gold Rush of 2019 - 21st Aug 19
How to Play Interest Rates in US Real Estate - 21st Aug 19
Stocks Likely to Breakout Instead of Gold - 21st Aug 19
Top 6 Tips to Attract Followers On SoundCloud - 21st Aug 19
WAYS TO SECURE YOUR FINANCIAL FUTURE - 21st Aug 19
Holiday Nightmares - Your Caravan is Missing! - 21st Aug 19
UK House Building and House Prices Trend Forecast - 20th Aug 19
The Next Stock Market Breakdown And The Setup - 20th Aug 19
5 Ways to Save by Using a Mortgage Broker - 20th Aug 19
Is This Time Different? Predictive Power of the Yield Curve and Gold - 19th Aug 19
New Dawn for the iGaming Industry in the United States - 19th Aug 19
Gold Set to Correct but Internals Remain Bullish - 19th Aug 19
Stock Market Correction Continues - 19th Aug 19
The Number One Gold Stock Of 2019 - 19th Aug 19
The State of the Financial Union - 18th Aug 19
The Nuts and Bolts: Yield Inversion Says Recession is Coming But it May take 24 months - 18th Aug 19
Markets August 19 Turn Date is Tomorrow – Are You Ready? - 18th Aug 19
JOHNSON AND JOHNSON - JNJ for Life Extension Pharma Stocks Investing - 17th Aug 19
Negative Bond Market Yields Tell A Story Of Shifting Economic Stock Market Leadership - 17th Aug 19
Is Stock Market About to Crash? Three Charts That Suggest It’s Possible - 17th Aug 19
It’s Time For Colombia To Dump The Peso - 17th Aug 19
Gold & Silver Stand Strong amid Stock Volatility & Falling Rates - 16th Aug 19
Gold Mining Stocks Q2’19 Fundamentals - 16th Aug 19
Silver, Transports, and Dow Jones Index At Targets – What Direct Next? - 16th Aug 19
When the US Bond Market Bubble Blows Up! - 16th Aug 19
Dark days are closing in on Apple - 16th Aug 19
Precious Metals Gone Wild! Reaching Initial Targets – Now What’s Next - 16th Aug 19
US Government Is Beholden To The Fed; And Vice-Versa - 15th Aug 19
GBP vs USD Forex Pair Swings Into Focus Amid Brexit Chaos - 15th Aug 19
US Negative Interest Rates Go Mainstream - With Some Glaring Omissions - 15th Aug 19
GOLD BULL RUN TREND ANALYSIS - 15th Aug 19
US Stock Market Could Fall 12% to 25% - 15th Aug 19
A Level Exam Results School Live Reaction Shock 2019! - 15th Aug 19
It's Time to Get Serious about Silver - 15th Aug 19
The EagleFX Beginners Guide – Financial Markets - 15th Aug 19
Central Banks Move To Keep The Global Markets Party Rolling – Part III - 14th Aug 19
You Have to Buy Bonds Even When Interest Rates Are Low - 14th Aug 19
Gold Near Term Risk is Increasing - 14th Aug 19
Installment Loans vs Personal Bank Loans - 14th Aug 19
ROCHE - RHHBY Life Extension Pharma Stocks Investing - 14th Aug 19
Gold Bulls Must Love the Hong Kong Protests - 14th Aug 19
Gold, Markets and Invasive Species - 14th Aug 19
Cannabis Stocks With Millennial Appeal - 14th Aug 19
August 19 (Crazy Ivan) Stock Market Event Only A Few Days Away - 13th Aug 19
This is the real move in gold and silver… it’s going to be multiyear - 13th Aug 19
Global Central Banks Kick Can Down The Road Again - 13th Aug 19
US Dollar Finally the Achillles Heel - 13th Aug 19
Financial Success Formula Failure - 13th Aug 19
How to Test Your Car Alternator with a Multimeter - 13th Aug 19
London Under Attack! Victoria Embankment Gardens Statues and Monuments - 13th Aug 19

Market Oracle FREE Newsletter

The No 1 Gold Stock for 2019

Beware of the Stock Market Valuations Trap

Stock-Markets / Stock Market Valuations Dec 10, 2008 - 09:56 AM GMT

By: Money_Morning

Stock-Markets

Diamond Rated - Best Financial Markets Analysis ArticleLouis Basenese writes: this your warning…

With thousands of stocks down 50% (or more), investors are salivating over the bargains. But for every true deal, there are at least three “value traps” - stocks destined to languish at depressed levels indefinitely. Or worse, get cheaper still.


Think Kmart Corp. here. In late 2001, it became the poster child for value investors. They argued it was dirt cheap based on countless metrics like book value and sales. And it was destined for a historic turnaround.

Sure enough, the stock went from the bargain bin to the trash heap, as the company filed bankruptcy in early 2002.

So, before you go bargain hunting in this market, arm yourself with this list. It could be your only chance to avoid getting snared by the countless “Kmarts” begging for your investment…

10 Questions You Should Be Asking

In theory, a value stock is a beaten-down company that's 1) cheap compared to its earnings, its competitors and/or some other relevant benchmark and 2) poised for a turnaround.

In contrast, a value-trap is simply a beaten-down company that's cheap compared to its earnings, its competitors and/or some other relevant benchmark, but never quite turns it around.

Unfortunately, no formula exists to calculate when, or if, a turnaround will ever occur. But, these 10 questions should help. And ultimately, keep you out of most value traps…

  1. Is there a near-term catalyst?
    First things first, if there's nothing on the horizon - like a new product launch, key marketing arrangement, a shake-up of the executives, the conversion of a massive order backlog, etc. - we shouldn't bother. Companies and stocks need catalysts in order to advance. If none exist in the next 12 to 18 months, chances are the stock will be stuck in neutral, or worse, reverse.
  2. What are insiders doing?
    Nobody knows the company - and its future prospects - better than the insiders. If they're not salivating over the “cheap” prices and backing up the truck, we shouldn't either.
  3. Is the company addicted to debt?
    Too much debt magnifies the impact of tough times. As sales decrease, interest payments take up more and more of the company's earnings. Not to mention, unwinding leverage is a time-consuming process. So, even if the company boasts new, fiscally responsible management, beware. Or as Warren Buffett observes, “When a management with a reputation for brilliance takes on a business with a reputation for bad economics, it's the reputation of the business that remains intact.”
  4. Does the dividend yield seem too good to be true?
    Value investors love to tout they “get paid to wait” for a turnaround. Granted, many stocks do maintain their dividends through a downturn. But countless others don't. They slash or cancel them altogether, just to stay in business. No matter how tempting, tread carefully when the dividend yield hits double-digit levels.
  5. Is the company just as “cheap” based on the future?
    At first glance Eastman Kodak Co. ( EK ) appears dirt cheap, trading at a price-to-earnings (P/E) ratio of 2.96. But don't be fooled. Or get too easily excited. Remember, the P/E ratios cited on most financial websites are historical. And as investors, we don't care what a company was worth… we care about what it will be worth. So before you buy, make sure the stocks forward P/E ratio is similarly attractive. (FYI - Eastman's is not. It trades at 27 times forward earnings. Hardly cheap.)
  6. Which direction is the company's market share headed?
    A general economic slowdown is one thing. But when a company's losing market share, too, that's an indication that a competitor has a better mousetrap. And while economic growth is cyclical, market share is not. Even if the economy or industry turns around, chances are the company's market share won't.
  7. Does the company operate in a highly cyclical or moribund industry?
    If you go hunting in a highly cyclical industry (like semiconductors) you're asking for trouble. Same goes for industries destined for obsolescence (like print media). To win with these stocks, you need both the company's misfortunes and the industry's to reverse course.
  8. How's the free cash flow?
    Earnings can be massaged, manipulated or completely fabricated. But cash cannot. So, make sure free cash flow is stable, or growing. If nothing less, it provides management with a little wiggle room, or margin of error when considering ways to speed up a turnaround.
  9. Is the stock liquid enough?
    Just like insiders provide support to share prices, so do institutions (mutual funds, pension plans, hedge funds, etc). Both groups can move stocks prices quickly and significantly. However, many institutions can't or won't buy stocks trading for less than $10, with a market cap below $1 billion and/or that don't trade several million dollars worth of shares each day. Without the potential for institutional ownership, a quick rebound in prices becomes less likely.
  10. Does the company have a sustainable competitive advantage?
    For a stock to turnaround we need the company to thrive, not survive. That's not possible without a sustainable competitive advantage. So stick to companies like Apple Inc. ( AAPL ) that are light-years ahead of the competition in terms of design, market share, new product offerings and/or technology.

In the end, don't kid yourself. Detecting a value trap is no easy task. Even the best investors occasionally get snared. Think Bill Miller (with Countrywide and Freddie Mac ( FRE )) and Carl Icahn (with Yahoo! Inc. ( YHOO ) and Advanced Micro Devices Inc. ( AMD )).

But at the very least, these 10 questions will ensure you never buy blindly, or on price alone.

[ Editor's Note : For additional insights on value investing, check out Investment Director Keith Fitz-Gerald's recent special investment research report on the same topic: The Five Keys to Value Investing Profits .]

[Editor's Note: Louis Basenese is the Associate Investment Director of The Oxford Club and regular contributor to Investment U . He is one of the top analysts and most sought after speakers on financial topics in the country. The following article first appeared in Investment U . But because of the quality, we wanted to share it with Money Morning readers ]

By Louis Basenese
Contributing Writer
Money Morning

Money Morning/The Money Map Report

©2008 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules