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?