11 Crucial Issues for Investors to Consider in Value Stocks

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

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.

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