Too much reliance on simple value measures alone in stock analysis can lead you into costly “value traps.”
You need an eye for value to succeed as an investor. But focusing on value measures alone can steer you into unsuccessful investments that are sometimes referred to as “value traps.”
Some of the measures that lead you into value traps are statistical. They include unusually high dividend yields, unusually low per-share price-to-earnings or P/E ratios, or a low ratio of stock price to book value or other measures of per share value.
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Any of these measures can make it seem like a stock is a bargain. But in fact, any of them can simply be due to a low stock price that is the result of selling by well-informed investors who recognize a dismal long-term future.
Another way to fall into a value trap is to put too much faith in the value of a brand name. A strong brand can sell a lot of a strong product, or keep an over-the-hill product going long after competitors have faded. But even the strongest brand name can only do so much.
How an iconic brand name became a value trap
Eastman Kodak provides an instructive example of an iconic brand name that still got lost in a technological dead end. In the final decades of the last century, books on branding often pointed to Kodak as an enduring brand that lasted for many decades. In fact, the company’s branding efforts led to the coining of the term “Kodak moment.” For a time, it seemed like part of the English language, but now it is nearly forgotten.
The company built its business by selling cheap cameras and profiting on film sales. It invented the digital camera in the 1970s. However, exploiting this discovery would have forced the company to come up with a new business plan, so it chose to stick with its film-based approach. This worked for a time but the stock entered a gentle decline at the start of the previous decade. The decline turned into a plunge in mid-2007.
Even after it began to drop, Kodak attracted some diehard value-seekers who were drawn by its high dividend yield, and the fact that it was trading at very low values. But not many hung on through the inevitable unravelling as the company filed for bankruptcy protection early in 2012 and subsequently began a sale of its assets.
You can draw a number of business and investing lessons from this example. But the overriding one is this: Take a broad view of each investment you choose. Make sure it has more than one or even a handful of indicators to recommend it. That’s because every indicator ever invented is bound to steer you wrong eventually.
Here are some tips for avoiding value traps:
Review a company’s finances going back 5 to 10 years. The types of investments we recommend have a history of profits going back for at least that long. Companies that make money regularly are safer than chronic or even occasional money losers.
Review a company’s 5 to 10 year record of paying dividends. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds.
However, be wary of any value stocks with an unusually high dividend yield. Investors should avoid judging a company based solely on its dividend yield (the percentage you get when you divide a company’s current yearly payment by its share price). That’s because a high yield can sometimes be a danger sign rather than a bargain. For example, a dividend paying stock’s yield could be high simply because its share price has dropped sharply (because you use a company’s share price to calculate yield) in anticipation of a dividend cut. As we mentioned above, this can be a telltale sign of a value traps.
Ask yourself, does it have freedom from business cycles? Demand periodically dries up in “cyclical” businesses, such as resources and manufacturing. You can hold some value stocks from those sectors, but look as well for companies, especially in manufacturing, that have broad product lines or products that are indispensable.
Value stocks may have a hidden asset in their relationship with loyal customers. After a series of satisfactory dealings, long-time customers develop a level of trust that makes them receptive to related offerings from the company. For example, Apple Computer was able to move into the digital music player and smartphone businesses as quickly as it did in the past decade because it had an established core of fans for its Mac computers. This customer loyalty can help businesses mitigate the value trap.
What is the most surprising collapse of a well-known stock that you have seen? Did its collapse affect you directly as an investor? If you had to select one iconic stock today that you think might become a value trap in the future, what would it be? Let us know what you think.
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