10. Know When Cash and Asset Analysis Is Worthless.

You have heard about the risks of looking too deeply at book values. There is another time when investors get wrapped up looking at balance sheets with too much faith. Sometimes there is an event in a company that may garner a major hit to earnings or may create a big loss. When shares tank and investors look at the stated cash or assets on a balance sheet, they are often looking back at numbers that likely just no longer matter.

If a company had $2 billion in cash at the end of a year, that value does not matter if you consider that the entire cash amount could be targeted by shareholder suits, outside lawsuits, taxing agencies or regulatory capital issues, or if the company has to spend it all under new tests or product recalls. This effort of cash and asset review has been a trap that has wrecked many biotech and financial investors around bad news, where they might put too much faith on what the balance sheet indicates.

Accounts receivable can also create a value trap — what if a company’s top customer just went bankrupt, or if it just had a portion of its assets frozen? Suddenly a company may not have the earnings power ahead. Another instance that can spell trouble around revenue recognition is the “days sales outstanding” or DSOs. Rising DSOs can sometimes imply that companies are stuffing the channel or shipping products out the door when customers are delaying payments or holding their cash tightly.

When companies run into big problems, the cash that value investors are trying to evaluate may already be spoken for in liabilities tomorrow. When companies have problems with accounts receivable, it can sometimes end up with revenue recognition woes ahead. Value investors need to often be rather critical of their faith in cash and receivables.

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11. Three Drastic Instances of Value Traps Where Fraud Was a History Lesson.

There are many generalities that can be inferred from a review of what makes a value stock into a value trap. Sometimes the best lesson can be exact references of value traps. The following are some of the most extreme cases of the modern era, but they will highlight some of the risks in quite specific examples where many value investors got trapped and ruined.

Enron: This house of cards was an energy powerhouse that was the envy of the world in the late 1990s and into 2000. What most investors did not understand was that there was massive fraud top to bottom with fake profits and shells. Enron looked dirt cheap for a while, and management (crooked management that is) was adamant in its defense and encouraged even its employees to invest all in. Enron looked cheap, but even its debt holders and creditors took huge haircuts.

Ultimately, the only real value the Enron shareholders had was if they took physical delivery of their shares to sell to collectors as wall art. Authentic stock certificates of Enron frequently sell for more than $50 on eBay, but that is nothing compared to the losses suffered by its investors.

Worldcom: This house of cards also was a fraud from the top to the bottom, but it was a failed acquisition of Sprint that really got the value trap crowd in trouble here. Management was selling a great growth story, and then they were selling a great value story when the accusations of accounting fraud started coming out. This train wreck took place over a long period as many investors just could not believe what was happening.

Similar to Enron, WorldCom stock certificates can fetch as much as $50 on eBay and elsewhere for those who are into scripophily.

Tyco: One company that grew and grew in the 1990s was Tyco. This was an amalgamation effort of Dennis Koslowski in which he kept making acquisition after acquisition. There was an incredible value in many of the companies acquired and in many of the units of Tyco, but management taking money out of the company and accounting issues led to an 80% share price drop. Many of Tyco’s former units live on today, but many value investors were sucked into the value trap here and were stuck for many years.

One lesson of Tyco’s rise and fall is also not found just in management thinking the company is their personal piggy bank. Companies who only grow larger and larger by making acquisitions often run into problems. Even if no intentional wrongdoing took place, how high are the odds that an error can be made just around accounting system changes from one company to the next.

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