The bull market may be approaching 10 years old, but a big nasty market sell-off and a more cautious tone from the financial media can unnerve even sophisticated investors. One strategy that investors have used and done well with over time is investing in value stocks. In a down market, value stocks can be defensive because they are already cheap or down and out. In a rising stock market, investors may still keep looking for value stocks because they may be the only area that hasn’t screamed higher with the exponentially more expensive growth stocks.
24/7 Wall St. and its founders have evaluated stocks, bonds and other asset classes for many years now. And the so-called value stocks can be among the most misunderstood of all sectors and classes in equities. Many investors see low price-to-earnings (P/E) ratios or high yields and then improperly evaluate a company based on how cheap it looks. Value investors want a bargain, but in that bargain hunt they often ignore or overlook the signs that they are just falling into a proverbial value trap.
The one rule of making money in any market is to buy low and sell higher. 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.
Investors need to consider numerous issues in value investing. Stocks that appear to be cheap are almost always cheap for a reason. Investors who invest in value also must understand that they should never pile into a value stock all at once. Cheap stocks tend to keep getting cheaper before the market finally pays attention. There is generally a lot more to a story than a simple P/E ratio or just looking at past balance sheets and assets. Dividends, accounting errors, tax issues and management fraud call all act to put value investors right into those value traps.
24/7 Wall St. has identified 10 specific areas that investors need to consider when it comes to value investing. These hold true in up markets and in down markets. There are of course many more issues that should be considered, but these are among the major value investing pitfalls. After all, many companies are at least somewhat unique compared with peers, and that means that their value may not correlate 100% to their closest competitors nor to the broader stock market.
A frequent adage is that those who ignore history are doomed to repeat it. Those who ignore some of the basic traps in value investing are doomed to lose money, and they may pay a far larger price than they bargained for. Some investors may even lose all of their investment as their timing or making a quick decision leads investors into owning a company they didn’t want or understand for years.
Here are 10 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, regulations 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 make it look cheap.