Avoid Buying A Value Trap

| August 31, 2011

Traders have a lot of funny sayings about stocks, almost all of them filled with contradictions…

“What goes up, must come down” or “Don’t try to catch a falling knife” come to mind immediately.

These highly generalized statements apply accurately to many different things.  They’re overly simplistic statements of common sense.  I mean really, who would try to catch a falling knife?

But one market adage holds credence above all others.  Interestingly, it’s the one most often misinterpreted by investors.  It’s been said by many people in various ways, but here’s my favorite phrasing…

“I’m a buyer when others are selling and a seller when others are buying.”

I’m sure you’ve heard this saying before.  Its most often attributed to the single greatest value investor of all time, Warren Buffet.

You see, Mr. Buffet believes that when investors are panicking, it’s the best time to buy.  Prices are down and values can be found.  Another great quote from the Oracle of Omaha… “I’m in the business of buying.”  This means he’s always looking for companies to buy.  He’s constantly searching for real value.

So how do you find real values for your portfolio?

First off, it’s important to be able to recognize a value.  Unfortunately, many investors I talk to are looking at a single facet of a stock to determine its value… the price.  Or a massive price drop to be more specific.

And this is often where investors can end up buying a value trap instead of a value stock.  They’re so excited by the price drop, they merely glance over the fundamentals.  And they often ignore the one characteristic that defines most value stocks… a strong dividend.

So what is a value trap?

You may have heard the term before, but not known what it really means.  To help you make better choices, I’m going to explain what a value trap is.  Then I’m going to give you a great example to help illustrate my point.

First, here’s the best way to define a value trap…

  • A stock that has experienced a large drop in price and is mistaken to be a value stock, based solely on price.

Ok, so now you know the definition of a value trap.  It’s basically mistaking a stock with a large price drop for a value stock.  But not every stock that sees a big price drop is a value.  So how do you avoid buying one?

Here’s the deal…

To avoid value traps, you first need to know what makes a stock a value stock.  There are many different definitions in use today.  For example, one investor may use the price to book ratio, while another uses the price to cash ratio.

But they all focus on the fundamentals, including the payment of a dividend.

To get you started, here’s one metric universally accepted as a baseline for valuation.  Price to earnings, or P/E for short, compares the price of a stock to the company’s earnings per share.  You simply take the stock price and divide it by their earnings to come up with the number.

And the lower the P/E, the better the value in most cases…

To show you what a true value stock looks like, we’re going to look at a specific company.  It’s a stock I’ve written about in the past… USA Mobility (USMO).

USMO, a specialty communications provider, is trading around $15.10.  At this price, it’s 17.2% below the 52-week high of $18.25.  So it has the first component of a value stock… a big price drop.

But what makes it a value stock is the insanely low P/E of 3x! It is well below the industry average P/E of 16.8x.  In other words, you pay a lot less for every dollar of earnings with USMO than you would to buy one of their peers.

And don’t forget the dividend.  USMO is currently yielding 6.4%!

The bottom line is I see a stock in a stable industry, with a P/E of 3x, trading 17.2% below its 52 week high.  And they’ll pay me a $1.00 per share in dividends.  Now that’s what I call a value stock!

Now that you’ve seen a great value stock, let’s look at a value trap.  As you may know, not every stock trading lower by 17% is a value stock.

As we said earlier, you need to make sure the company can meet a valuation test.  And you’re hopeful the company is paying some kind of dividend (a true value stock will have a relatively high dividend yield).

But an uninformed investor may want to buy a “growth” stock in a hot new field, thinking it’s a “value stock”… all because of a massive price drop.

And here’s a company that fits the bill perfectly… eLong Inc. (LONG).

This Chinese internet travel company has seen its share prices drop significantly from the recent high of $29.60.  In fact, shares have fallen over 39.2%.  In such a hot new field, it must be a steal, right?

Not exactly…

Currently, LONG has a P/E of 142x on earnings of just $0.12.  And the forward P/E is a lofty 32.2x based on projected earnings of $0.53 per share.  Both P/Es are much higher than the industry average P/E of 28.7x.

So an investor doing a quick glance at the chart may say, “Wow, what a steal!  The stock has to rebound.”  Let me just say, if I had a nickel for every time I’ve heard that…

The reality is you’re looking at a company based in China, where some company data is sketchy at the moment.  And even if the numbers are accurate, you’re paying 32x projected earnings.  And they don’t even pay a dividend!

In my opinion, LONG is a perfect example of a value trap!  Its price drop of nearly 40% will drag many unsuspecting investors into its snare.  And many will mistakenly believe they’re buying a value stock.

Well it’s not a value stock.  And if you’re really looking for a value… you have no business buying LONG.

When looking for value stocks, you need to focus on finding companies with proven track records, solid fundamentals, and other metrics indicating “value”.  And don’t forget, a true “value stock” will always pay a good dividend.

With these few keys, you can find plenty of high quality value stocks.  And most importantly, you can avoid falling into a costly value trap.

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Category: Stocks

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