Investing

11 Crucial Issues for Investors to Consider in Value Stocks

Jon C. Ogg

Published: February 8, 2017 9:25 am

Last Updated: January 12, 2020 3:03 pm

The one rule of making money in investing is to buy low and sell higher. The issue to consider is that there are many paths used by equity investors to get there. Some investors want growth, others want income. And some investors want to feel like they are getting to buy a stock at a bargain. It is that bargain effort where value stocks come into play. Investors have to understand that there are many reasons why stocks look cheap at any given time, and this is where investors can easily get caught in a so-called value trap.

24/7 Wall St. and its founders have evaluated stocks, bonds and other asset classes for many years now. One issue that is often baffling is how and why many investors improperly evaluate companies. Value investors want a bargain, but they often ignore or overlook the signs that they are just falling into the proverbial value trap.

It is important to consider numerous issues in value investing. Stocks that appear to be cheap are almost always cheap for a reason, and investors need to understand never to jump in all at once. There is generally a lot more to a story than a simple price-to-earnings (P/E) ratio or just looking at past balance sheets and assets. Dividends, accounting errors, tax issues and management fraud call all wreck a good value story.

24/7 Wall St. has identified 11 specific areas that investors need to consider when it comes to value investing. Of course, many more issues should be considered. After all, companies tend to be at least somewhat unique, and that means that their value may not correlate 100% to their closest competitors nor to the market in general.

Investors who ignore some obvious signs about when value stocks are merely value traps often pay a big price. Sometimes they lose all their investment, or sometimes their timing or quick decision making leads to them owning a company they didn’t want or understand for years.

Here are 11 crucial issues for all investors to consider when it comes to deciding when to invest or not to invest in value stocks.

1. Cheap Stocks Are Cheap for a Reason (or Many Reasons).

When screening for cheap companies, beware what “cheap” really means. If a stock is valued at 10 times earnings when the S&P 500 is valued at 17 times earnings, there may be issues around low growth, asset sales, competition, regulation or myriad other issues. The “efficient market theory” may falter from time to time, but it suggests that the market is never really that wrong and that the market values companies and assets properly based on the known and unknown information at that time.

Regardless of what rationale investors and analysts are using to determine how “cheap” a stock or asset is, they have to know going in that there is probably a big reason or a series of reasons that made it look cheap.

2. Never Go All-In With a Value Stock.

Quite frequently value stocks look cheap, and it already has been stated that there can be many reasons why they look cheap versus peers or the market. It seems in at least some ways that the reason a stock looks cheap is less important than a poker adage of “going all in.” Never go all-in on a single value stock. Some companies never recover from past woes. Some top management teams falter (or they may even die) before turning a ship around. If a stock is valued far less than peers, generally speaking the only impetus that suddenly will reverse its bad fortune is if a competitor or private equity firm believes it can run the company better.

The biggest lesson is not just for individual investors to keep too much of their assets in one company, but to not just buy all at once and not all at the same price. Averaging in, or “nibbling” or “legging,” is the only way to go on a value stock. Investors almost never find a true bottom in value stocks, and there often are many times when cheap stocks get even cheaper. Again, they look cheap for a reason, and it can take years for a value scenario to unfold. This is where investors need to concede that the market may remain irrational for longer than the rest of us can remain solvent.

The same “never all-in” lesson should be considered when it comes to earnings or other upcoming events — if a value stock is cheap because of poor history, what are the odds that the next earnings or corporate news reaction is going to overwhelmingly positive?

3. More to a Story Than P/E Ratio (and the PEG Ratio Trap).

At the start of 2017, the S&P 500 was valued at close to 19 times trailing earnings per share and more than 17 times expected earnings per share for fiscal year 2017. These valuations may be high by historic standards of 15 times expected earnings, but the reality is that earnings growth was expected to be close to 10% and interest rates remained quite low. Stock sectors are valued quite differently from each other, and these premiums and discounts change over time. Established banks, telecoms and utilities might have lower P/E ratios than industrials and technology, but that does not make them cheap. When individual companies trade at 10 times expected earnings and the S&P 500 (or their sector) is valued at 15 to 20 times expected earnings, the market is not willing to pay much for the future value on the current earnings. There can be many reasons for the disparity, but the market never really improperly discounts a company or a sector for very long.

The PEG (price/earnings to growth) ratio is where investors look at a price-to-earnings multiple versus earnings growth rates. The problem here is that most investors focus on historic growth rates rather than future growth rates. So this PEG ratio often makes many companies look cheap after a hiccup or business change, causing them to just be value traps. Companies can grow earnings for 25% for 10 years, but if their growth is about to slow to 15% or 10% then their PEG ratio simply does not matter using 25% growth in the calculations. Even using a new lower growth number doesn’t work if the earnings are set to be under pressure or face sporadic trends. Falling for a cheap PEG ratio can make many companies look cheap in screens, but it is the growth rates ahead and the quality of future earnings that matter more than the growth rates of the past

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4. Beware When Dividends Are Too High Versus Peers.

Many stocks have large numbers of investors who are solely focused on the dividends or distributions. After years of tracking telecom, master limited partnerships (MLPs) and other high payout sectors, we can tell that if a company’s dividend exceeds earnings and distributable cash flows per share, then it is being funded from somewhere. Maybe it is taking on debt or eating into its cash from past years. Regardless, companies with high dividend (and distribution) yields often find themselves in the middle of a short seller war. If AT&T and Verizon yield close to 4.5%, telecoms with a 7% or 8% yield may have more risk. If a typical utility stock yields 3.5%, the yields of 5% may have more risks from earnings, regulation or other business issues.

The biggest risk about high dividends and distributions is when they have to be cut or eliminated. If investors think a stock looks cheap because of a high dividend, they are likely to be stunned when they see what happens to the share price after a dividend gets lowered or eliminated. It can be a very painful lesson.

5. Accounting Concerns (or a Going Concern).

If a company is “cheap” in a screen because it has accounting concerns, investors better understand that they probably do not and cannot really understand what they are getting into. If the term “accounting irregularities” is seen, these companies might have problems for many years. They often get the dreaded “earnings restatements,” in which years of earnings history has to be reworked, and shareholders generally get hurt in those situations.

Then there is the “going concern” note from an auditing firm, where the firm says a business has a risk as a going concern. That means a company may not be viable, or that if it does not turn its ship around it is doomed.

These have something in common to when you walk in your kitchen at night and see a roach — what are the odds that this is the only roach in the house?

6. Watch Out When Analysts Stay Bullish Thesis for Too Long.

Analysts may be smart in general, and they may have high knowledge of their fields. Unfortunately, many analysts expect too much from companies they cover. They often just assume that things will always be good ahead, even when business interruptions get in the way of investor gains. Sometimes stocks will drop 20%, 30%, 50% or more, and it is common to see analysts react by maintaining Buy or Outperform ratings even as they lower their formal price targets. This is often a very bad sign. There are of course exceptions, but it can mean that there is more hope and promise in a bullish case than there is meat.

In many value investing cases, the lesson about analysts being too bullish should also mean that investors should not universally trust analyst earnings and revenue estimates. This plays deeper into the lesson of there being more than a P/E and PEG Ratio to the value story. Many value stocks have a big chance of disappointing investors around earnings and other planned corporate news. Again, they look “cheap” for a reason. Major growth drivers do not grow endlessly (think about drug sales, new phone launches, new food trends, etc.).

Just like the rest of us, analysts hate to admit being wrong. Also keep in mind that at almost all times there are more Buy or Outperform analyst ratings on Wall Street than there are Hold, Neutral, Sell and Underweight analyst ratings combined.

7. Beware the Traps of Book Value.

Many companies get screened based on their stated book value. This is the balance sheet review of assets minus liabilities in the simplest form, and then compared to the overall market cap. Many companies have high levels of goodwill or other intangible assets that can skew these numbers. Some companies have a value on their balance sheet that may be quite different (for better or worse) than what the assets could be sold for.

Gold companies and oil companies have book values that are highly or entirely subject to the price of the underlying commodities. Financial companies (banks, brokerages, insurance and the like) have book values that can be tied to assets valued by the financial markets. Any measure of these can make a book value screen almost worthless. If the price of oil drops 25% in 90 days, does the value of underlying reserves on the books mean that much from 90 days earlier?

The real lesson around book value that often proves fatal for investors is that the so-called “value” may be highly subjective. In many cases, the book value on a balance sheet is completely worthless.

8. When Stocks Look Cheap Just Because the Share Price Tanked

Many value investors love trolling through companies with a stock that just fell 30%, 50%, 70% or even more. Balance sheets and other valuation metrics often look cheap after you take 30% to 70% off of a stock price. This is a silly way for investors to fall into a value trap. It is not normal for a stock to drop by the double-digit percentages overnight. Nor is it common to occur in a period of days or weeks. Still, sometimes it may look like the market is the real reason for a drop.

From 2011 to 2016 there were very few instances where the Dow Jones Industrial Average or S&P 500 fell by more than 10%. Now consider that many stocks fell more than 10%, and some stocks fell 30%, 50% or far more. Maybe the reason was because of the price of oil or other commodities. Maybe it was because earnings or a series of other bad news trends. Maybe their underlying fundamentals were changing.

Whatever the reason or logic for a rapid drop in a stock, no stock is suddenly “cheap” just because its stock price fell sharply. Weak stocks, particularly in a strong market, are more likely to be attractive to short sellers than they are to ‘smart money’ institutional buyers.

Now consider this investor adage as a warning — stocks that hit 52-week lows often keep hitting new 52-week lows for quite some time.

9. When Growth Stocks Become Value Stocks.

The stock market loves stories of endless growth year after year. Many companies are considered to be “growth stocks” rather than value stocks, but eventually the laws of large numbers or the threat of competition come into play. When a company’s revenue growth has been 20% per year and it captures a large enough share of its market, growth rates are going to eventually drop or they may peak at some point. These periods of slowing growth, or the end of growth, can be incredibly painful periods for shareholders. Just think about what happened around slowing growth of Under Armour, Apple, Gilead Sciences, Cisco Systems and many other great growth stories.

Many analysts and investors refuse to accept that growth rates are slowing as fast as the actual numbers suggest, or they get caught thinking the growth rates can continue endlessly. It is rather painful when the market has been willing to pay 40 times expected earnings and then the market is only willing to only pay 25 times expected earnings.

The end lesson here about value versus growth is that trying to take a value approach into a slowing growth story seems to be a scenario that generates much more pain than reward for investors.

10. Know When Cash and Asset Analysis Is Worthless.

You have heard about the risks of looking too deeply at book values. There is another time when investors get wrapped up looking at balance sheets with too much faith. Sometimes there is an event in a company that may garner a major hit to earnings or may create a big loss. When shares tank and investors look at the stated cash or assets on a balance sheet, they are often looking back at numbers that likely just no longer matter.

If a company had $2 billion in cash at the end of a year, that value does not matter if you consider that the entire cash amount could be targeted by shareholder suits, outside lawsuits, taxing agencies or regulatory capital issues, or if the company has to spend it all under new tests or product recalls. This effort of cash and asset review has been a trap that has wrecked many biotech and financial investors around bad news, where they might put too much faith on what the balance sheet indicates.

Accounts receivable can also create a value trap — what if a company’s top customer just went bankrupt, or if it just had a portion of its assets frozen? Suddenly a company may not have the earnings power ahead. Another instance that can spell trouble around revenue recognition is the “days sales outstanding” or DSOs. Rising DSOs can sometimes imply that companies are stuffing the channel or shipping products out the door when customers are delaying payments or holding their cash tightly.

When companies run into big problems, the cash that value investors are trying to evaluate may already be spoken for in liabilities tomorrow. When companies have problems with accounts receivable, it can sometimes end up with revenue recognition woes ahead. Value investors need to often be rather critical of their faith in cash and receivables.

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11. Three Drastic Instances of Value Traps Where Fraud Was a History Lesson.

There are many generalities that can be inferred from a review of what makes a value stock into a value trap. Sometimes the best lesson can be exact references of value traps. The following are some of the most extreme cases of the modern era, but they will highlight some of the risks in quite specific examples where many value investors got trapped and ruined.

Enron: This house of cards was an energy powerhouse that was the envy of the world in the late 1990s and into 2000. What most investors did not understand was that there was massive fraud top to bottom with fake profits and shells. Enron looked dirt cheap for a while, and management (crooked management that is) was adamant in its defense and encouraged even its employees to invest all in. Enron looked cheap, but even its debt holders and creditors took huge haircuts.

Ultimately, the only real value the Enron shareholders had was if they took physical delivery of their shares to sell to collectors as wall art. Authentic stock certificates of Enron frequently sell for more than $50 on eBay, but that is nothing compared to the losses suffered by its investors.

Worldcom: This house of cards also was a fraud from the top to the bottom, but it was a failed acquisition of Sprint that really got the value trap crowd in trouble here. Management was selling a great growth story, and then they were selling a great value story when the accusations of accounting fraud started coming out. This train wreck took place over a long period as many investors just could not believe what was happening.

Similar to Enron, WorldCom stock certificates can fetch as much as $50 on eBay and elsewhere for those who are into scripophily.

Tyco: One company that grew and grew in the 1990s was Tyco. This was an amalgamation effort of Dennis Koslowski in which he kept making acquisition after acquisition. There was an incredible value in many of the companies acquired and in many of the units of Tyco, but management taking money out of the company and accounting issues led to an 80% share price drop. Many of Tyco’s former units live on today, but many value investors were sucked into the value trap here and were stuck for many years.

One lesson of Tyco’s rise and fall is also not found just in management thinking the company is their personal piggy bank. Companies who only grow larger and larger by making acquisitions often run into problems. Even if no intentional wrongdoing took place, how high are the odds that an error can be made just around accounting system changes from one company to the next.