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The Value Investor's Handbook: Value Traps

3 ways to tell if you have a value trap on your hands Continue reading... Read More...

This new series called “The Value Investor’s Handbook” will hopefully be of use for value investors everywhere. My aim is not to produce an exhaustive guide of absolutely everything that a value investor should know. Such a lofty goal would, I suspect, be unattainable. Remember that even the best investors are always learning and refining their processes.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Instead, what I want to do is provide the budding value investor with a list of useful heuristics – rules of thumb – that should get them thinking about stocks in the way that Benjamin Graham and Warren Buffett (Trades, Portfolio) would approve of. In my first installment to the series, I teased the idea that not all falling stocks are good value – sometimes, things are cheap for a reason. We refer to these types of stocks as value traps. Here are three common attributes of value traps.” data-reactid=”12″>Instead, what I want to do is provide the budding value investor with a list of useful heuristics – rules of thumb – that should get them thinking about stocks in the way that Benjamin Graham and Warren Buffett (Trades, Portfolio) would approve of. In my first installment to the series, I teased the idea that not all falling stocks are good value – sometimes, things are cheap for a reason. We refer to these types of stocks as value traps. Here are three common attributes of value traps.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Debt” data-reactid=”19″>Debt

Leverage is a poison pill that has sunk many a company in the past, and will continue to do so in the future. The effect of debt on a company’s finances only really shows up in the balance sheet. This can become a problem for less attentive investors who only look at the income statement, particularly for those who only look at earnings per share, a metric that the financial news media seems to have singled out as the most important part of a company’s quarterly disclosure, but that in reality is rather meaningless when viewed out of context.

If the company you are analyzing has a lower-than-average valuation and a significant debt load, chances are you have a value trap on your hands. To make matters worse, a company can get stuck in a debt spiral, where deteriorating finances drive up the cost of financing debt, which just exerts more pressure on the company’s treasury. For these reasons, a high debt load is a sign that you should avoid the business.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Competition within the industry” data-reactid=”22″>Competition within the industry

One of the most important tasks for an analyst is determining whether a stock has sold off because of a short-term hiccup or whether there is a larger structural change happening within its industry. Competition from a new arrival in a sector, who has introduced new products or business practices, can cause a company to lose market share. The job of the analyst is to figure out whether this new challenger presents an insurmountable problem, or whether management is putting in place a good enough plan to deal with it. If the answer is the former, then you likely have a value trap on your hands.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Industry-wide decline” data-reactid=”24″>Industry-wide decline

Sometimes, a stock will look cheap due to pressure from outside the industry, not from within. Over the last 50 years, technologies have come and gone: radio was displaced by television, newspapers were displaced by the internet and Blockbuster was displaced by Netflix (NASDAQ:NFLX). I’m sure many people bought Blockbuster stock when it first started selling off in the mid-2000s. Of course, things that seem obvious in retrospect are rarely obvious in the moment. But if it were easy, everyone would do it. Just make sure the stock that looks so cheap isn’t the new Blockbuster.

Disclosure: The author owns no stocks mentioned.

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<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="This article first appeared on GuruFocus.
” data-reactid=”34″>This article first appeared on GuruFocus.

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