8. A Stock Is Not 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 fell 30%, 50% or far more. Maybe the reason was the price of oil or other commodities. Maybe it was because of earnings or a series of other bad news trends. Maybe their underlying fundamentals were changing. Either way, stocks that perform horribly will keep selling off in a bad market, and they often underperform when the market rebounds.
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.
There is a key lesson to back this up: 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 law of large numbers or the threat of competition comes 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 eventually going to peak or moderate at some point. These periods of slowing growth, or the end of growth, can be incredibly painful periods for shareholders. Go back in time and 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. Some analysts get caught putting in endless growth into their forecasting models just because of a company’s history. It can be rather painful when the market has been willing to pay 40 times expected earnings and then the market is suddenly 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.
10. Knowing 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 and not enough common sense. 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 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. And what if a company has to spend all that cash for new tests or product recalls after a disappointment? This effort of cash and asset review has been a trap that has wrecked many biotech and financial investors around bad news in which too much faith is put on what the past balance sheets indicate.
Accounts receivable also can create a value trap. If a company’s top customer just went bankrupt, or if it had a serious business interruption, then customers may choose to hold their cash rather than pay their bills entirely. 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. And higher DSOs may even suggest that their customers are running into performance issues and are slower to pay.
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.