11 Major Risks for Value Investors With Stocks at All-Time Highs


The bull market is now well into its 10th year, and many investors have been scratching their heads, trying to figure out how to be positioned heading into 2020. On top of an upcoming election and the media constantly warning that the next recession could be imminent, the Dow Jones industrial average, S&P 500 and the Nasdaq Composite have all challenged all-time highs in July.

Is this a time for investors to consider rolling out of growth and into value? Some investors might choose the safety of lower valuations and dividends over some of the high-growth stocks. However, value investors had better be very cautious about what sort of “value” they are looking for.

One steadfast rule of investing is not to fight the tape. In short, if the market or a sector keeps ticking up, it might not be best to look at the stocks that are down and out. If a stock is hitting 52-week lows when the market is hitting all-time highs, imagine how crummy it might be in a bad market. Still, some investors want to feel like they are getting to buy a stock or a sector when they are at bargain prices and valuations.

Value investors have to understand that there are many reasons why stocks look cheap at any given time. If the market is valued at 18 times expected earnings, then stocks valued at eight times and 10 times expected earnings have to sound dirt cheap. There is usually a reason for that. This is where value investors can get caught easily in a so-called value trap.

24/7 Wall St. and its founders have evaluated stocks, bonds and other asset classes for many years now. One issue that remains puzzling is how and why many investors improperly evaluate companies and sectors during a bull market. Value investors want a bargain, but they often ignore or overlook the signs that a value trap is just about to eat into their assets.

It is important to consider numerous issues and risks in value investing. Stocks that appear to be cheap are usually cheap for a reason. It’s also important in value investing that when those “buy levels” become too tempting an investor should never try to jump in all at once. “Cheap stocks” aren’t just cheap for a reason, but they usually stay cheap for more than just a few days or weeks.

There is almost always more to an investing thesis than a simple price-to-earnings (P/E) ratio. There is also more than just looking at past balance sheets and assets to determine what a fair value happens to be. Dividend cuts, accounting errors, tax issues, shareholder suits, product liabilities and management fraud call all take a good value story and balance sheet down the drain.

24/7 Wall St. has identified 11 specific areas that investors need to consider when it comes to value investing now that the stock market has again challenged new all-time highs. With the Dow at 27,000 and the S&P 500 having crossed the 3,000 level for the first time, it makes sense to be cautious in stocks and sectors that are down 20% or 30% from their highs.

Companies tend to have unique stories, regardless of what is happening in the market or the economy. Just look at the world of conglomerates at this stage of the bull market and try to pinpoint just one or two key issues in each to figure out why they look “cheap” in an expensive market. Ditto for steel and metals stocks, and why are so many transportation and financial stocks screening out as “cheap” and not participating as much as the broad market rally would suggest? It is also easy to find brick-and-mortar retailers valued at less than 10 times earnings in 2019, but that is because the investing community is worried about existential risks from the online and multichannel threats from the likes of Amazon and a few other behemoths.

Investors must pay attention to the obvious signs about when value stocks really are value traps at a time when the stock market is hitting all-time highs. If investors are not careful, they could face substantial losses or they could lose their entire investments. Moreover, falling into a value trap often comes with a cardinal sin of accidentally owning a company that they just did not really understand.

Here are 11 crucial issues for all investors to consider in “value stocks” and “value investing” when the stock market is hitting all-time highs.

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 18 times earnings, there may be issues around low growth, asset sales, competition, regulation 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 made it look cheap.

2. Never (Ever) Pile Into a Value Stock All at Once!

Quite often, value stocks look cheap, and it already has been stated that there can be many reasons why they look cheap versus peers or the market. It seems in at least some ways that the reason 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 there often are many times when cheap stocks 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 will be overwhelmingly positive?

3. More to a Story Than P/E Ratio (and the PEG Ratio Trap).

At the start of 2017, the S&P 500 was valued at close to 19 times trailing earnings per share and more than 17 times expected earnings per share for fiscal year 2017. These valuations may be high by historic standards of 15 times expected earnings, but the reality is that earnings growth was expected to be close to 10% and interest rates remained quite low. 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 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, the market 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 really never 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 versus earnings growth rates. The problem here is that most investors focus on historic growth rates rather than future growth rates. So this PEG ratio often makes many companies look cheap after a hiccup or business change, causing them to be just 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 Versus 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 sectors that have high payout ratios of income or cash flow, we can tell that if a company’s dividend exceeds earnings and distributable cash flows per share then it is being funded from somewhere else. Maybe it is taking on debt or eating into its cash from past years. Or maybe it is cash from a one-time event like a unit-sale or asset sale. Regardless, companies with high dividend (and distribution) yields often find themselves in the middle of a short seller war. If companies like AT&T and Verizon have yields of 4% to 6% already, telecom and communications carriers yielding 8% to 10% likely come with much more risk. If a typical utility stock yields 3.5%, then yields of 5% or 6% may have more risks from earnings, regulation or other business issues.

The biggest risk about high dividends and distributions is when they have to 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 is 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, these companies might have problems for many years. They often get the dreaded “earnings restatements,” in which years of earnings history has to be reworked, and 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.

These accounting situations have something in common to when you walk in your kitchen at night and see a roach on the counter. What are the odds that this is the only roach in the house?

6. Watch Out When Analysts Keep Their Bullish Thesis for Too Long.

Analysts may be smart in general, and they may have high knowledge of their fields. Unfortunately, many analysts expect too much from companies they cover. They often just assume that things will always be good ahead, even when business interruptions get in the way of investor gains. 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. Sometimes they remain positive even after cutting their earnings and/or price targets multiple times. This is often a very bad sign. There are of course exceptions, but it can mean that there is more hope and promise to their bullish thesis than there is meat.

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 than a P/E and PEG Ratio to the value story. 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, new food trends, etc.).

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 Around 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 greatly 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 spot asset prices in 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? If the value of financial assets at a bank (loans and investments) falls by 20% in a few months, does it really matter what the prior stated book value per share was before that drop?

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. Beware Stocks Looking 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 a stock price. This is frequently 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 see a drop of that magnitude over a period of days or weeks.

Sometimes it may look like the market is the real reason for a drop. From 2011 to 2018, there were very few instances where the Dow Jones industrial average or S&P 500 fell by 10% from the peak at that time. Now consider that many stocks fell more than 10%, and some stocks fell 30%, 50% or far more. That probably wasn’t the stock market’s fault. Maybe it was because of the price of oil or other commodities. Maybe it was because earnings or a series of other bad news trends. Maybe it was because of company-specific or industry-specific exposure to trade and tariffs. Maybe the underlying fundamentals were changing.

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.

Now consider this investor adage as a warning: stocks that hit 52-week lows often keep hitting new 52-week lows for quite some time.

9. It Hurts When Growth Stocks Become Value Stocks.

The stock market loves stories of endless growth year after year. Many companies are considered to have “growth stocks” rather than value stocks, but eventually the laws of large numbers or the threat of competition come 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 eventually are going to drop or they may peak at some point. These periods of slowing growth, or the end of growth, can be incredibly painful periods for shareholders. Just think about what happened around slowing growth in prior years around the Gap, Dell and HP, Gilead Sciences, IBM, Under Armour 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. Sometimes they get caught thinking the growth rates can continue endlessly. And sometimes they fall into thinking the PEG ratio matters when earnings growth is suddenly peaking. It is rather painful for investors when the market has been willing to pay 40 times expected earnings for years and then suddenly the market is only willing to only pay 20 times expected earnings. Do the math, and if the earnings didn’t more than double during that P/E compression, then you can probably guess what happened to the share price.

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. Know 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. Sometimes an event in a company 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 likely just will not matter in the coming months and quarters.

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 authorities, government agencies or regulatory issues. If a company has to spend all of their cash for new tests or to deal with product recalls or other liabilities, that cash may simply be history. This effort of cash and asset review has been a trap that has wrecked many biotech and financial investors around bad news, where they might put too much faith on what the balance sheet indicates.

Accounts receivable can also create a value trap — what if a company’s top customer just went bankrupt or a dispute arose? Or what if a customer just had a portion of its assets frozen? Suddenly a company may not have the earnings power ahead, and it may be no fault of the company being evaluated. 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.

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 often need to be rather critical of their faith in cash and receivables.

11. Three Drastic Instances of Value Traps Where Fraud Was a History Lesson.

Many generalities can be inferred from a review of what makes a value stock into a value trap. Sometimes the best lesson can be exact references of value traps. The following are some of the most extreme cases of the modern era, but they will highlight some of the risks in quite specific examples where many value investors got trapped and ruined.

Enron: This house of cards was an energy powerhouse that was the envy of the world in the late 1990s and into 2000. What most investors did not understand was that there was massive fraud top to bottom with fake profits and shells. Enron looked dirt cheap for a while, and management (crooked management that is) was adamant in its defense and encouraged even its employees to invest all in. Enron looked cheap, but even its debt holders and creditors took huge haircuts.

Ultimately, the only real value the Enron shareholders had was if they took physical delivery of their shares to sell to collectors as wall art. Authentic stock certificates of Enron frequently sell for more than $50 on eBay, but that is nothing compared to the losses suffered by its investors.

Worldcom: This house of cards also was a fraud from the top to the bottom, but it was a failed acquisition of Sprint that really got the value trap crowd in trouble here. Management was selling a great growth story, and then they were selling a great value story when the accusations of accounting fraud started coming out. This train wreck took place over a long period, as many investors just could not believe what was happening.

Similar to Enron, WorldCom stock certificates can fetch as much as $50 on eBay and elsewhere for those who are into scripophily.

Tyco: One company that grew and grew in the 1990s was Tyco. This was an amalgamation effort of Dennis Koslowski in which he kept making acquisition after acquisition. There was an incredible value in many of the companies acquired and in many of the units of Tyco, but management taking money out of the company and accounting issues led to an 80% share price drop. Many of Tyco’s former units live on today, but many value investors were sucked into the value trap here and were stuck for many years.

One lesson of Tyco’s rise and fall is also not found just in management thinking the company is their personal piggy bank. Companies who only grow larger and larger by making acquisitions often run into problems. Even if no intentional wrongdoing took place, how high are the odds that an error can be made just around accounting system changes from one company to the next?

Smart Investors Are Quietly Loading Up on These “Dividend Legends”

If you want your portfolio to pay you cash like clockwork, it’s time to stop blindly following conventional wisdom like relying on Dividend Aristocrats. There’s a better option, and we want to show you. We’re offering a brand-new report on 2 stocks we believe offer the rare combination of a high dividend yield and significant stock appreciation upside. If you’re tired of feeling one step behind in this market, this free report is a must-read for you.

Click here to download your FREE copy of “2 Dividend Legends to Hold Forever” and start improving your portfolio today.

Thank you for reading! Have some feedback for us?
Contact the 24/7 Wall St. editorial team.