10 Crucial Issues for Value Stock Investors in a Down Market

Jon C. Ogg
2. Never Go All-In at Once in a Value Stock.

Value stocks quite frequently look cheap, and again there can be many reasons why a stock looks cheap compared with peers or the market. It seems in at least some ways that why 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 cheap stocks often 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?

3. There Is More Than Just a Low P/E Ratio and the PEG Ratio Trap.

In 2018, stocks are valued at higher earnings multiples than in prior years, but well short of previous bubble levels when considering financial ratios. 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 automatically 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, it generally implies that the investing community 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 to earnings to growth) ratio is where investors look at a price-to-earnings multiple compared with earnings growth rates in recent years. The problem here is that most investors using PEG ratios are focusing on historic growth rates rather than on realistic future growth rates. PEG ratios often make many companies look cheap after a hiccup or business change, and they end up as 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 Compared With 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 in a potentially unsustainable manner. 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 investors are finding high yields in telecom and tobacco stocks, then the value proposition may be due to limited growth opportunities. If a typical utility stock yields 3.5%, the competing yields of 5.0% may have more risks from earnings, regulation or other business issues.

The biggest risk about high dividends and distributions is when they could 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.