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.
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