10 Crucial Issues for Value Stock Investors in a Down Market

October 11, 2018 by Jon C. Ogg

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.

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.

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.

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.