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, investors may be looking at a company that can have problems for many years. These types of companies often get the dreaded “earnings restatements,” where years of earnings history are reworked. 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. Suddenly, even a company looking cheap on the balance sheet may be a value trap.
These situations have something in common with walking in your kitchen at night and seeing a roach. If there is one roach, what are the odds that are many more roaches in the house?
6. Watch Out When Analysts Stay Bullish for Too Long.
Analysts who follow stocks may be smart in general, and they may have high knowledge of their fields. Unfortunately, many analysts expect way too much from companies they cover. They often just assume that things always will be good, even when business interruptions come up. 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 sign that more bad things are coming down the pipe, even it seems coincidental. There are many exceptions to the analyst rules, but sometimes analysts fall into the trap of thinking about hope and promise in a bullish case rather than looking at how much meat there is on the bone.
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 to the value story than a P/E and PEG ratio. 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 and new food trends).
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.
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.