Avoid falling into a value trap.
The cyclical nature of the stock market means that even popular stocks sometimes trade at a discount. Long-term value investors recognize that market downturns are typically only temporary, and they swoop in to buy stocks at a discount. However, sometimes a stock’s downturn is more than just a cyclical lull and can be a sign that something is critically wrong with the company’s underlying business. In these cases, a struggling stock may appear to offer a compelling value when it’s actually a value trap. Here are a few ways to recognize and avoid value trap stocks.
It has declining revenue.
Market price-earnings multiples expand and contract, and these fluctuations can account for much of a stock’s short-term price movement. However, a company with consistently declining revenue often has a major problem with its business. Sears Holding Corp. (ticker: SHLD) shares are down 77 percent in the past five years, but the company’s revenue has also steadily declined by 48 percent in that time. Companies with declining revenue can stay profitable for years by cutting costs and relying on business from their remaining loyal customers. Unfortunately, when revenue is disappearing, long-term value is typically disappearing as well.
The P/E ratio is suspicious.
P/E ratio is one of the classic value investing metrics. P/E is a measure of how much investors are paying for $1 of earnings per share of stock. Stocks trading at a P/E in the teens may potentially offer long-term value. But when a P/E looks too good to be true, smart investors should be skeptical. Retailer Bed Bath & Beyond (BBBY) has a P/E of 6.7, but its net income is down 35 percent in the past three years and its share price is down 54 percent in that time.
It’s a troubled business.
Sometimes it doesn’t matter how well a company is run or what management does to save it if the company’s business model has become obsolete. Movie rental giant Blockbuster’s market cap once peaked at more than $5 billion, but its well-documented fall from grace culminated with its stock being delisted back in 2010. Blockbuster stayed profitable for years while it slowly lost customers to online streaming competitors like Netflix (NFLX). When even the top companies in a given business are struggling, it may be a sign that there’s a critical problem in that particular industry.
The dividend yield is extremely high.
Dividends can augment value investors’ returns. But much like a suspiciously low P/E, a suspiciously high dividend yield is a red flag. Since dividend yield is calculated based on share price, a falling stock inherently produces a higher yield. For companies with oversized dividends looking to cut costs, dividend payments are often first on the chopping block. Frontier Communications Corp. (FTR) is the highest-yielding dividend stock in the Standard & Poor’s 500 index, paying out a 16 percent yield. The company likely never intended to pay such a high yield. The stock is down more than 80 percent in the past year.
Debt levels are extreme.
Debt can be another troubling sign hidden just below a stock’s surface. Typically, companies that rely on heavy debt loads do just fine during times of economic prosperity. But while most stocks are impacted by economic downturns, companies that rely on borrowing can be completely wiped out if the credit market dries up. In late 2007, shares of casino operator Las Vegas Sands Corp. (LVS) traded well above $100 per share. By early 2009, they had fallen as low as $1.06 due to fears that the company’s $10 billion in debt would ultimately trigger a bankruptcy.
There’s new competition.
Sometimes a stock’s potential value can be compromised by new competition in the market. Investors who thought BlackBerry (BBRY) was a bargain back in 2010 when its P/E dipped below 13 were treated to an 80 percent decline in share price over the seven years that followed. There’s no way of knowing where the stock would have ended up if the Apple (AAPL) iPhone hadn’t stolen BlackBerry’s smartphone thunder. But BlackBerry is an excellent example of how even a single competitor can completely wipe out a company’s market cap.
Beware of a fad.
It’s great when a company’s product or service catches on like wildfire, but long-term investors need more than just a fad. When the Pokemon Go craze took the world by storm in 2016, some Nintendo Co. investors thought they were getting a great value. Nintendo stock spiked as high as $38 within a matter of days. However, as enthusiasm for the game faded, Nintendo’s share price was soon back below $28. Even if a product is successful, it’s only a value for investors if that success endures in the long term.
Growth numbers are a red flag.
Sometimes a stock can look like a tremendous value based on the growth numbers it is delivering, but it always pays to look at where that growth is coming from. Companies often turn to mergers and acquisitions as a means to boost sluggish earnings and revenue growth. While there’s nothing inherently wrong with growing via buyouts, that type of growth only lasts as long as the deals keep coming. After years of buyout-fueled market gains, Valeant Pharmaceuticals (VRX) stock came crashing back down to earth recently when investors became skeptical of its ability to deliver organic growth.
Insiders aren’t buying.
If a stock is trading at a share price that offers tremendous value, the first people to recognize that value should be company insiders. There are plenty of websites that have searchable databases of insider transactions. If a stock seems like a great value at first glance but no company insiders are buying it, there’s probably something you’re missing about the company. It’s part of management’s job to talk up a company’s future prospects on quarterly earnings calls and in interviews with the press. However, if they aren’t personally buying the stock, actions speak louder than words.
More from U.S. News
7 Notable Quotes From Warren Buffett
10 Skills the Best Investors Have
12 Terms Every Investor Needs to Know
9 Ways to Spot Value Trap Stocks originally appeared on usnews.com
