Detecting Frauds. When to Sell. Avoiding Value Traps.

 

Filter out noise and focus on information that are important for investing.

VALUE TRAPS

How do you decide whether it is a value trap or not?

Value traps are statistically very cheap and very alluring.

First question to ask:  “Why is God so kind on you that you are the only one who has this tremendous insight that this stock is cheap and all the other people who are very active, smart and intelligent in the market are ignoring this company?”

Is there an embedded growth optionality in the company? Can the company have a growth phase? Can the company come out with some new product offering which can introduce growth? 

This is a dynamic exercise.  You will need to revisit the hypothesis every now and again, at intervals. 

Two characteristics of value traps are:

• (1)  They typically don’t tend to grow more than the nominal GDP
• (2)  They cannot reinvest their cash flow.

So the question you should ask is what is the catalyst which will change this and allow them to reinvest the capital which they are throwing off?  In its absence, you have a classic example where the company had great cash flows and no catalyst.  

Your sole focus of whether to participate in a seemingly value trap could be you calling out the catalyst that will catapult it out of this situation.

Value traps in real life.

Company X is a private limited company that owns a lot of assets.  It owns plantations, factories, shop houses and various businesses.   Its net book value is very high.   If it can sell off everything at the fair market price, it should be worth a lot of money.

It has many shareholders.  Many are from the same related brothers and sisters.  There are also many outsiders who own shares in the company.   

The company makes good profit every year and is cash rich.   It is well managed.  It chooses to distribute a small portion of the yearly profits as dividends and retains the major portion as cash which is  kept in the bank.   Every year its net book value increases due to its retained earnings.   The shareholders get their dividends without fail, though these have not increased through the years, despite the company earnings having improved over the period.  

The management remains sound and those in control of the management and the directors enjoy their fees for their services, which are fair and reasonable.

The company continues to grow its assets and earnings over the years.  Its assets, which are land, properties and businesses have appreciated a lot over the very many years.

Alas, some shareholders wish to cash out.  Who are the buyers?  Yes, some of the shareholders are still accumulating the shares in the company regularly.   There are also many who also are not willing to buy, not because the company is not good and also not because it is overvalued.   They do not wish to tie their money up in the company as they cannot see how they will be rewarded in the coming years.  Except for the dividends received yearly, which weren't much when you compared with the yields from the risk free fixed deposit rates, they just cannot see how they can cash out of this company at a fair price.  The buyers have indicated that they are always available for those who wish to cash out, but the price offered is about half that of the net book value.   This state of affair existed for many years and continues till today.

Are there similarities we can observe in some of the listed companies who are deemed value traps too?

A simple approach to the present bear market (fair value, bargains, value traps)

So the stock market has gone down the last few weeks.  You as a value investor is excited, searching for companies to invest for the long term.. 

Here is a very simple way to look at the businesses that are in the stock market:

1.  Those that are still fairly valued, even though the prices are lower than before (FAIR prices).
2.  Those that are under-valued (BIG bargains at present day prices).
3.  Those that are value traps (the values of these companies may go down to zero, therefore these are BAD bargains here;  avoid, avoid and avoid.)

Price is NOT value.   Price is what you pay, value is what you get.

You are looking to buy GREAT COMPANIES AT FAIR OR BARGAIN PRICES.

You are also looking to buy GOOD COMPANIES AT BIG BARGAIN PRICES.

You should avoid buying GRUESOME COMPANIES AT ANY PRICES (VALUE TRAPS).


Wishing you success in your investing.  

When is a bargain not a bargain?

Once you have assembled a list of likely bargain candidates, you have to determine

• which to put your money into and 
• which to avoid and move on.

Many of the companies in your initial list are cheap for a reason;; they have fundamental problems that make them decidedly not valuable.

On the list of value candidates whose stock price had fallen significantly in the past were Enron, Global Crossing, MCI, US Airlines and Pacific Gas and Electric.   These companies ended up filing for bankruptcy and shareholders lost a significant portion of their investment if not all their money.


To achieve your wealth-building goals, you have to determine 

• why a company's shares are cheap and 
• which ones have little chance of recovery.

1.  Too much debt

The first and most toxic reason that stocks become cheap is too much debt.  In good times, companies with decent cash flow may borrow large amounts of money on the theory that if they continue to grow, they can meet the interest and principal payments in the future.  UNFORTUNATELY, the future is unknowable, and companies with with too much debt have a much smaller chance of surviving an economic downturn.  

Ben Graham explained that he used a simple yardstick to measure health.  A company should own twice as much as it owes.  This philosophy can help you avoid companies that owe too much to survive.


2.  Company falls short of analysts' earnings estimates.

Analysts seem to be more focused on short-term earnings gains than future long-term success   These quarterly or yearly earnings estimates have been proven to be notoriously unreliable.  Routinely, large and good companies get pushed to new stock price lows because they missed the estimates of the thundering herd of Wall Street  Missing earnings is not fatal, and it tends to create opportunity for the value buyer; if the trend continues, however, the shares will likely continue to fall.


3.  Cyclical stocks

Some cyclical stocks may show up on your list of potential bargains.  They are highly dependent on how the economy is doing.  Industries like automobiles, large appliances, steel and construction will experience lean times and stock prices are likely to reflect this fact.   Although we have had recessions of varying lengths and depths, the economies of industrialised nations have always rebounded.  It is important to note that in the bad times, cyclical companies with heavy debt loads may well face insurmountable problems.  Adhering to a policy of avoiding overly leveraged companies will serve you well.


4.  Labour contracts

Stocks may also fall because of labour contracts.  During good times, some companies and industries cave into labour union demands that were affordable at the time.  Little did they realize that they were mortgaging their future.  As new competition unburdened by costly labour contracts enters their industries, their profits disappear.  In many cases, the unions have been unwilling to grant concessions.   It is never easy to give back something you have, even if not doing so threatens the very existence of the company you work for.  Although holding on to expensive contracts may or may not benefit management or the unions in the long run, the one person that most assuredly does not benefit is the stockholder.  

Many large corporations (old-line industrial companies) have pension liabilities - benefits promised to workers - that they simply will be unable to pay  Generally speaking, if a company has excessive pension liabilities or there exists a contentious labour environment, it may be best to put these companies' shares on the no-thank-you list.


5.  Increased competition

Highly profitable industries attract new competition.  The most serious form of this comes when an industry in one country has high-priced labour or expensive regulatory rules.  Other nations unburdened by such costs can often produce and export the same goods cheaper.  Think China.  Throughout the world, countries have seen foreign manufacturers of automobiles, appliances and other goods make significant inroads into their market.  If a company is facing strong competition from a more efficient competitor with lower costs, it is perhaps best to utter those comforting words "no, thank you" and move on to the next candidate.


6.  Obsolescence

Obsolescence is another potentially fatal cause for falling prices.

Although the last large scale manufacturer of buggy whips or hand-cranked automobile starters made a very fine product, there was simply no longer a need for its product.  There may be some small demand for these products, but a company that depended on them for most of its sales would soon be out of business

Consider the field of technology.  The rate of "creative destruction" has never been faster.  Newer and better products turn up every day making the older products obsolete  The new products are a boon to the consumer but the bane of the legacy company.  

Today, we can go online and order any movie from NetFlicks and never have to leave the comfort of your own home.  For this reason, you should avoid companies that are subject to technological obsolescence.  The world is simply changing too fast to depend on products and services that someone else can deliver better and for less cost.  Avoid these.


7.  Corporate or accounting frauds

These are perhaps one of the most dangerous reasons for share price drops is corporate or accounting fraud.

Although these crimes against investors are the exception and not the rule, and most CEOs are dedicated leaders who care about their companies and their shareholders, fraud does happen.  In recent years, the world has experienced some of the largest cases in history, Enron, Parmalat, Tyco, WorldCom and others.  Regulators have since done much to help prevent future occurrences but there will always be some form of shenanigans.

Criminals exist in every walk of life.  There is almost no way to uncover fraud before it becomes public.  By the time it is discovered, it is too late  The best the investor can do is to steer clear of financial reports that seem overly complicated.


8.  Companies you do not understand or are not comfortable with

If there is something you do not understand or are not comfortable with, put these in the no-thank-you pile.   If a company has too many problems - too much debt, union and pension problems, stiff foreign competition, they too go to the no-thank-you pile.  You have the luxury of filling your portfolio with stocks you are comfortable with and want to own for the long term wealth building it offers.



Summary

You should approach your list of investment candidates with a healthy dose of scepticism.

You should stick to businesses you understand and for which there is an ongoing need (products or services).

You should also like food, beverage, and consumer staples like detergents, toothpaste, pens, and pencils - the stuff you consume on a daily basis. Many of these products engender brand loyalty that keeps the same product day after day, week after week.  We are all creatures of habit, and we will usually repeat our consumer preference when we go shopping.

Your best friend in the whole investing world is your no-thank-you pile.  Knowing your no-thank-you pile gives you the value investing opportunities to build your wealth building portfolio.

To avoid falling into a value trap, an investor must always keep asking, "why"?

Once you find an undervalued security trading at a substantial discount to your estimate of intrinsic value, your job is not over. 

"Why is the stock trading at this level and what catalysts will lead to its eventual reversal?" 

If you cannot answer this question, you should not be investing in the stock. 

This is second level thinking (Howard Marks) and it will keep you from falling into a value trap. 

An investor must always keep asking, "why"? 

• Why is this occurring? 
• What is the overarching reasoning or justification behind this particular scenario or occurrence? 

When you have those answers, you have to ascertain why the other side may (or may not) be wrong. 

• Is there are mispricing here? 
• There was a major disconnect between perception and reality - between the stock price and the intrinsic value of the business. Why? 

There can be from any number of reasons. Usually one or the other side is wrong from psychological or analytical misjudgements (sometimes both).

Why You Should Invest in Growth, Not Value

by Alexander Green, Investment U Chief Investment Strategist

Tuesday, September 25, 2012

Patrick Henry famously declared that he knew no way of judging the future but by the past.

So if you're putting together a long-term investment portfolio, it might be wise to look at the historical returns for various types of assets. Not just for the past few years, or for several decades, but for the past couple centuries...

When you do this, you'll notice something interesting:

·        Owning a portfolio of businesses (stocks) has generally been much more rewarding than making loans to corporations or Uncle Sam (bonds) or sticking your money in the bank (cash).

·        Look closer at the clear winner (equities) and you'll also find that value stocks have outperformed growth stocks over the long haul and that small-cap value has beaten large-cap value by a substantial margin.

It therefore follows that an investor seeking maximum capital appreciation might focus on identifying undervalued small-cap stocks.

But there's only one problem with this: It won't work for most investors, even if the future is very much like the past. Here's why...

Beware the Infamous Value Trap

Value stocks require something that growth stocks don't: Patience.

When a stock - either large or small - is in the cellar, it's there for a reason. Typical ones are that the company is:

·        Losing market share...

·        Seeing its margins fall...

·        Is losing money...

·        Or is experiencing flattish sales and declining profits.

As a value investor, you don't know when this state of affairs will end, but you might be tempted to invest in a company if it's relatively cheap in relation to sales, earnings, or book value (i.e. net worth) in the hope that management will set things right.

The problem is this can take quite a long time. Or it may never happen at all. As the stock gets cheaper and cheaper, you may believe it's becoming an even better bargain. This is the classic "value trap." And if you keep buying a stock on the way down, it may very well have your name on it when it hits rock bottom.

Dead Money With Decent Dividends 

Even if a value stock is destined to generate a good return over, say, a three- to five-year horizon, most investors won't be around to enjoy it.

How do I know this? Because as a former money manager, I've dealt with thousands of "typical investors." And regardless of what they say in their initial interview about their willingness to stay the course and think long term, it all goes out the window for 90% of them when the road gets bumpy. Or if things don't kick into gear right away.

A client who sits on a stock - or even a stock fund - for six months and doesn't see a spark will remind you with every conversation that he or she is sitting on "dead money."

No argument there - they are (at least temporarily). But value stocks often pay decent dividends that help compensate for this. Early in my career, however, I got tired of holding hands and counseling patience and switched from a value to a growth methodology.

It was a good move. If you want action, you should have it...

There's No Shortage of Excitement With Growth Stocks 

Buy the best growth stocks you can find. Given that they tend to be twice as volatile as the market (and twice as expensive), there is generally no shortage of day-to-day excitement.

But if you use a trailing stop, you can generate results that are much better than historical long-term returns (which always assume a buy-and-hold approach) and with less risk because your positions are fully protected.

So unless you have the patience of Job - and most investors don't - you're better off owning growth stocks than value stocks and, of course, using a trailing stop. 

Good Investing,

Alex

Bargain or Value Trap? (Morningstar)

How Long Is A Piece of Value?

How long do you wait for a value share to out? There's no easy answer.

You hear the term "value trap" used about a share offering ostensible value but which never seems to rise in order to realise what the investor perceives as its undervalue. I don't much like this expression because it suggests that the share will never out, and I'd guess it is probably used by disillusioned investors who have held for some time and are fed up with waiting.

I think most, if not all, value players -- certainly including myself -- have experienced this disillusionment. I'm not referring to a situation where the fundies have deteriorated so the value has actually been outed, though on the downside. That would be a clear sell to a value investor, even if a loss was the outcome.

I'm talking about a situation that continues to offer value in the investor's view, yet other investors, the market if you like, continue to disagree and stubbornly refuse to price up the share. It may have net cash, be on a low P/E, a high yield, trade below tangible book and any combination of these and other classic value criteria. And yet this goes on for years and you are scoring little or no profit or maybe losing.

To dump or not to dump?

To dump or not to dump? That is the question. Okay, if it has a decent yield, at least you are compensated to some extent for holding over a long period, which is one reason why I like a good yield in my particular version of the value game, the other being that yield is also a value indicator. But we're not here for the income, this is a capital gains approach and therefore thought should be given to what to do with a long-held play that just hasn't done the business despite all the indicators suggesting that it ought to have.

The basic faith of the value player is that, sooner or later, value must out -- it just must because it is seen as an anomaly that will be arbed out by the market eventually. But I don't see any way to estimate when "eventually" will occur. In an extreme case, it may not be even within the investor's practical investing lifetime -- especially if, like me now, they were grave dodgers when they first bought the share.

I have read at least one value writer who advocates selling a play that hasn't performed within a given period. I forget the exact details but let's say it's five years. If, after that time, it hasn't done it for you, then even if it continues to offer value, his view was that you should sell because it has become a value trap.

Better out than in?

But consider this. After those five years, a new value player arrives on the scene and discovers your share which, remember, still has attractive fundies. Because she is new to the share, she has no reason to share your disillusionment and on the contrary will be enthused by it.

So who is right? The weary old value player who has seen no action over five years and is seriously on the verge of dumping it, or the new value player who spies a potentially lucrative opportunity? If we assume they both have similar skills at spotting plays using the same criteria, they can't both be right.

The answer has to be that the new investor's opinion is the right one and that in consequence the existing holder should stay in. Tomorrow might be the day it outs. Or it might go another five years of nowhere, that's the risk both the existing and the new player takes.

This then begs the question whether the fact that a value share has done nothing for many years increases or decreases its attractions, or is irrelevant. Several arguments could be made either way. For example, the fact of not having outed for a long time could mean that it is now nearer doing so. But it could also mean  that not enough investors care about it, so that it may go on for a further lengthy period out in the cold. The best answer in my view is that it's irrelevant.

The bottom line for me is that there is not really such a thing as a value trap, they are probably just value shares that haven't yet outed and we cannot know when that may occur. I accept that it is certainly exceedingly frustrating to hold a play for years and to see it doing nothing despite continuing good fundies. I've been there myself many times.

This creates a great temptation to dump it, but to counter that, imagine you are a new value investor coming at it without the knowledge of its past price action. You'd buy, so why sell?

And that's why I have always said that enormous patience is required for the strategy.

http://www.fool.co.uk/news/investing/2012/01/05/how-long-is-a-piece-of-value.aspx?source=ufwflwlnk0000001

Price-Earning Ratio 101

What actually is PER?

It's often said that the PER is an estimate of the number of years it'll take investors to recoup their money. Unless all profits are paid out as dividends, something that rarely persists in real life, this is incorrect.

So ignore what you might read in simplistic articles and note this down: a PER is a reflection not of what you earn from a stock, but “what investors as a group are prepared to pay for the earnings of a company”.

All things being equal, the lower the PER, the better. 


But the list of caveats is long and vital to understand if you're to make full use of this metric.

PER:  Historical versus Forward or Forecast PER

The PER compares the current price of a stock with the prior year's (historical) or the current year's (forecast) earnings per share (EPS). Usually the prior year's EPS is used, but be sure to check first.

For example:

Last financial year, XYZ Ltd made $8 million in net profit (or earnings). 

The company has 1 million shares outstanding.

So it achieved earnings per share (EPS) of $8.00 ($8 million profit divided by 1 million shares). 

In the current year, XYZ is expected to earn $10 million; a forecast EPS of $10.00.

• At the current share price of $100, the stock is therefore trading on a historic PER of 12.5 ($100/$8). 
• Using the forecast for current year's earnings, the forward or “forecast PER” is 10 ($100/$10).

Quality has a price to match

Quality usually comes with a price to match. 


It costs more, for example, to buy handcrafted leather goods from France than it does a cheap substitute from China. Stocks are no different: high quality businesses generally, and rightfully, trade on higher PERs than poorer quality businesses.





Low PER doesn't alone guarantee quality business

• Value investors love a bargain. Indeed, they're defined by this quality. 
• But whilst a low PER for a quality business can indicate value, it doesn't alone guarantee it. 
• Because PERs are only a shortcut for valuation, further research is mandatory.
• 
  

High PER with strong future earnings growth maybe a bargain

• Likewise, a high PER doesn't ensure that a stock is expensive. 
• A company with strong future earnings growth may justify a high PER, and may even be a bargain. 
• A stock with temporarily depressed profits, especially if caused by a one-off event, may justifiably trade at a high PER. 
• But for a poor quality business with little prospects for growth, a high PER is likely to be undeserved.

Avoid a Common trap: Use underlying or normalised earnings in PER


There's another trap: PERs are often calculated using reported profit, especially in newspapers or on financial websites. 


But one-off events often distort headline profit numbers and therefore the PER. 


Using underlying, or “normalised”, earnings in your PER calculation is likely to give a truer picture of a stock's value.





What is a normalised level of earnings?

That begs the question; what is a normal level of earnings? That's the $64 million dollar question.


 If you don't know how to calculate these figures for the stocks in your portfolio, now is the time to establish whether it's skill or luck that's driving your returns. And if you don't know that, history may well make a monkey of you.




An old encounter with low PE stock: Hai-O


It is nostalgic to re-read an old post on Hai-O by ze Moola. 

http://whereiszemoola.blogspot.com/2008/04/more-on-haio.html

Sunday, April 13, 2008
MORE ON HAIO

My dearest BullBear,

A low PE stock means only one thing and that is the stock is trading on a lower valuation compared to what it is currently earning.

Some simply consider that what is happening is the stock is being ignored in the market despite its impressive earnings.

Why?

The market could be wrong and that perhaps this is a stock that's an ignored gem. Yeah, the classical hidden gem and if this is the case, investors who invests in the stock could be rewarded for their stock selection.

However, on the other hand, sometimes the market could be right and that they do sense something is not right within the stock.

And because of this reasoning, I have always realised that a low PE stock does not make a stock a QUALITY stock.

It just means the stock is trading 'cheaply'.

It could be a bargain but it could also be a trap.

Understanding Value Traps

If you believe a stock has an a true ("intrinsic") value, you will try to buy it below that level (when it's "cheap"). So why sell if it gets even cheaper.

A stock that stays at a large discount to intrinsic value is a "value trap". It's an important issue for value investors and there are are few methods of avoid value traps.

One way to avoid a value trap with a cheap stock (like Benjamin Graham liked) is to buy them with catalysts, i.e. new management or new plans to unlock that value through buybacks, dividends, or sale/merger.

The best way to avoid a value trap is to buy a growing business that increases value over time.

Is Poh Kong a Great, Good or Gruesome Stock? Is it Undervalued, Fair price or High price?

There is a rising trend in its EPS.  However, earnings are rather cyclical, as evidenced by its ups and downs.
Poh Kong has grown its revenue and earnings through opening new outlets.  Its SSS figures are probably stagnant (this need to be confirmed).  It has acquired a lot of debt in growing to its present size.  Though its recent CFO and FCF are strongly positive, its FCF will mainly be used for paying down its debt and reinvesting into new stores.  Its DPO is in the region of 20% of its earnings and its DPS has increased little if any over the years.

Its ROE in 2009 was 10.05%.

Is Poh Kong a Great, Good or Gruesome stock?
Not a Great stock.  Perhaps more a Good stock rather than a Gruesome stock.

So,  perhaps it is better to skip this stock and search for another.

But then, let's look at the fundamentals of Poh Kong.

http://spreadsheets.google.com/pub?key=tx8wcqGqfTVH8s7RRSy-19g&output=html

What should be its intrinsic value?  Note in particular, its net working capital minus total debt owed equals RM 146 m.

At a price of 39 cents, its market cap is RM 160 m.

Therefore, effectively, the investor is buying the whole business of Poh Kong for RM 14 m.

Is Poh Kong not undervalued?  Severely undervalued?

Moreover, owning this stock gives you a DY of 3.6%.  Given its strong FCF, this dividend level can probably be sustained and this should protect the downside of your investment dollar.  Therefore, the upside reward/downside risk ratio is also favourable.

Disclaimer:  Please invest based on your own assessment and decision.  Always do your own homework.

Also read:

What are value traps?

5 Value Traps to Avoid Right Now

 I’m all for buying stocks on the cheap.  But there’s a catch: We’re only interested in good values if they also happen to be great businesses, companies with years of exceptional performance behind and ahead of them. And, of course, ones that pay us to wait for our thesis to play out.


and this:
Understanding  "Value Trap"

What are value traps?

Above all else, we try to avoid value traps.

What are value traps?

Deysher: A value trap refers to a stock that looks cheap, probably is cheap, and stays inexpensive forever. It never appreciates because nothing really changes -- there‘s no growth or things don‘t get better. For some companies, it is difficult to change. The only way to make money is if they are acquired, which may never happen. Right now there are several companies that meet all of my other criteria, except that I feel they are value traps.

http://www.fundemail.com/pinnacle.html

5 Value Traps to Avoid Right Now

5 Value Traps to Avoid Right Now
By Joe Magyer
April 24, 2009 Comments (14)

History’s greatest investor, Warren Buffett, has two simple rules.

Rule #1: Never lose money.
Rule #2: Never forget rule #1.


A big, sarcastic thank-you, Warren!

Sure, practically everyone has lost money in this market -- including Buffett. But take it easy on the Oracle here, because he’s dead-on. Buffett’s intense focus on not just investing in great opportunities but avoiding terrible ones has been the key to epic success.

Avoiding soul-sucking investments -- what we investing nerds dub “value traps” -- is hardly rocket science. Yet, incredibly, I see investors new and salty alike make the same mistakes over and over again, breaking Buffett’s rules and walking right into what seem like obvious value traps.

Having spent way too much time thinking about it, I’ve concluded that there are five primary categories of these dreaded mistakes. Avoiding these five traps will save you time, money, and more than a little heartache.

1. The quarter-life crisis
These are a real heartbreaker. You find a dominant company whose once sky-high growth has stalled, and its shares along with it. “TechWidget Corp. is trading at only 15 times earnings right now, only half its five-year average!” you say. “Its earnings have doubled over the past five years, but the shares are down over the same time period. Sounds like a steal!”

Snap! You just walked into a value trap.

Investors falsely believe that names like Dell or eBay (Nasdaq: EBAY) will see their relative valuations return to their headier days. They won’t.

Why? Captain Obvious would say that growth has slowed, technology evolved, and competition emerged. But all that misses the real reason. Instead of returning incremental profits to shareholders via dividends, such companies wreck shareholder value by chasing growth through overexpansion and high-profile acquisitions. Oh, and the ill-timed share repurchases that exist primarily to juice per-share earnings and help sop up all that stock option-driven dilution.

Steer clear of flailing tech titans until they’re willing to follow the lead of Microsoft (Nasdaq: MSFT) and Oracle (Nasdaq: ORCL) into dividend-paying adulthood.

2. The soaring cyclical
Here’s the rub about cyclical stocks: Their valuations are counterintuitive. They always look the cheapest when they’ve reached their priciest, and look priciest when they’re reached their cheapest.

Take nearly any oilfield service stock from last summer as an example. Transocean (NYSE: RIG) looked dirt cheap via a crude, PEG-style valuation. But savvy investors know that cyclical companies’ profits mean-revert, which is why cyclical stocks’ P/E multiples stay low during booms and high during busts.

In other words, you should be looking at cyclical stocks as their P/Es expand, not shrink.

3. The small-cap Methuselah
The six-year small-cap bull run that came crashing to a halt last year was a painful reminder of a little-known value trap: the Small-Cap Methuselah.

Century-old small-caps you’d never heard of were wrapping up five-year runs of 20% annualized earnings growth. Analysts went gaga, extrapolating those growth rates forward like the party would never end. Valuations followed suit. Gaga analyst, meet mean-reversion.

You won’t find long-run compounding machines within the small-cap space. Show me a company with a long, proven history of creating serious shareholder value, and I’ll show you a mid- or large-cap stock.

4. The too-high yielder
A company usually has a high yield (think above 7%) for one of three reasons:

• It has limited growth potential, so managers return as much cash as they can to shareholders (think regional telecoms).
  


• The company is in a clear state of decline and investors expect a dividend cut (think newspapers).
  


• The company is in a tax-advantaged structure that doesn’t allow it to retain much capital (think REITs, MLPs, or BDCs).

Broadly speaking, a high payout is a good thing. There’s a fine line, though. At Motley Fool Income Investor, we’re looking for that sweet spot where an attractive payout meets rest-easy status.

Take my most recent recommendation, Procter & Gamble (NYSE: PG). The stock’s yield of 3.5% is near a multi-decade high despite the company’s underlying earnings power remaining unchanged, if not improving. That’s low-hanging fruit for the income-loving investor.

5. The unopened book
I can already see the Ben Graham fanatics gearing up to peg me with tomatoes, but hear me out. Book values need to be adjusted -- especially heading into and during recessions.

Acquisition-happy companies inevitably end up slashing the goodwill they’d booked while making bloated acquisitions in the years previous. The book values of asset-centric plays (homebuilders, natural resource producers, etc.) also need a good tweaking to reflect the depressed values of those assets. And financials, well, what can I say? Just ask any Citigroup (NYSE: C) or AIG (NYSE: AIG) investor about the ease of assessing their balance sheets.

Don’t get me wrong: I’m all for buying stocks on the cheap. We do just that at Income Investor. But there’s a catch: We’re only interested in good values if they also happen to be great businesses, companies with years of exceptional performance behind and ahead of them. And, of course, ones that pay us to wait for our thesis to play out.

But I digress.

Wrapping the traps
To recap, you can smooth and improve your returns if you:

1. Avoid the stalled-out growth stock undergoing a quarter-life crisis.
   


2. Steer clear of hot small-caps with blah track records.
   


3. Don’t get tripped up by seemingly cheap soaring cyclicals.
   


4. Think twice about the yield that looks too good to be true.
   


5. Don’t lean on inflated or unadjusted book values.
   

You’ve probably picked up on an underlying theme here: You need unconventionally conventional thinking if you want low-stress success in the stock market.

Looking for great, simple-to-understand businesses at good prices is the easiest way to avoid stepping into a value trap -- and bag great returns besides. That’s what I do alongside advisor James Early over at Income Investor, and more than 85% of our active picks are beating the market.

Senior analyst Joe Magyer owns no companies mentioned in this article, though he’s planning to nab a few. Microsoft, Dell, and eBay are Motley Fool Inside Value recommendations. eBay is also a Stock Advisor recommendation. Procter & Gamble is an Income Investor recommendation. The Motley Fool owns shares of Procter & Gamble. The Motley Fool has a disclosure policy.

Read/Post Comments (14) Recommend This Article (113)

http://www.fool.com/investing/dividends-income/2009/04/24/5-value-traps-to-avoid-right-now.aspx