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.
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