Value stocks have long been regarded as safer investments than growth stocks. They tend to sport lower valuations and are often dogged by low expectations. So any stumbles can be taken in stride.
But investors need to do their homework before pouncing on a value stock too quickly. A little digging can easily turn up red flags that take the shine off of any value play.
Here are five flaws to watch out for, because they can end up killing the value you're hoping to find:
Value investors tend to be attracted to stocks trading at less than book value (meaning the company's market value is less than the shareholder equity found on its balance sheet). Trouble is, if the company is losing money or taking major write-offs (information found over on the income statement), then shareholder equity is likely to erode.
To sidestep this landmine, look for "below book" stocks that are actually profitable. (For further reading on "below book" stocks, check out these 3 Deep Value Stocks With Major Upside.)
2. Cash flow that never becomes cash.
Analysts often tout stocks that appear cheap based on their cash flow. Indeed, cash flow is usually a very good metric, as it proves that a company can generate ample returns from its operations.
When a company is growing at fast clip, it makes sense for management to re-invest that cash flow back into the business, leading to even more growth down the road. But some companies seem perpetually stuck in reinvestment mode, continually pushing money back into the business in order to keep up with competition. So that cash flow never translates to rising cash levels.
For example, solar panel maker SunPower (Nasdaq: SPWRA) consistently generates positive operating cash flow, but heavy investment means that free cash flow is always negative. That's forced the company to repeatedly sell more shares to stay afloat, diluting existing shareholders.
3. An uncertain dividend yield.
High-yield dividend stocks are often seen as value stocks. They can provide an attractive source of income even if shares have limited potential for capital appreciation. But many investors mistakenly chase stocks with unusually high dividend yields. And extremely high yields -- in excess of 10%, for example -- can be a sign the dividend needs to be cut.
At the depths of the economic crisis, media firm Gannett (NYSE: GCI) offered a $1.42 annual dividend. When the stock moved below $7, it ended up with a dividend yield in excess of 20%. But the underlying problems that precipitated the stock's price decline eventually forced management to cut the dividend by 90%, and dividend chasers that didn't see it coming were burned. So it's important to see how operations are faring. If business has just turned south, a seemingly attractive dividend may be at risk.
4. Low P/E with declining E.
Stocks with low price-to-earnings (P/E) ratios often represent the best value, but only if earnings are flat or rising. Yet some investors buy low P/E stocks without noticing that earnings are in the midst of a long-term decline.
Internet access provider Earthlink (Nasdaq: ELNK) might have looked awfully tempting last year when shares traded for around $7 and earnings per share (EPS) looked set to come in above $2.50. That translated to a P/E ratio below three. But remember, as a new investor, you're paying for future earnings. And in Earthlink's case, profits are sinking fast as it loses customers. Sales are likely to fall -18% this year and another -15% next year. EPS is likely to be less than $1 this year, and could fall to $0.50 by 2012. Shares now trade for a richer 17 times that 2012 profit forecast, and that's no bargain.
As noted in the first item on this list, value measures that use book value should be taken with a grain of salt. Many companies carry assets on their books that don't necessarily correlate to actual real world values.
Some investors like to cite department store retailer Dillard's (NYSE: DDS) as a compelling value play. The company is valued at $1.8 billion, but the value of its real estate holdings is $2.7 billion -- +50% higher. But is it reasonable to assume the company would find any buyers paying full value for real estate when the world is awash in unused retail space? If the economy sharply improves, and empty retail stores are re-occupied, then the market value of Dillard's real estate would likely improve. But that's a big if, and it's certainly not applicable right now.
The Investing Answer: "Stocks are cheap for a reason" is a tried-and-true investing axiom. So when you come across a value stock, look for reasons against the stock, not for it. If you can't find any major problems among the financial statements or with investor assumptions about the future, then the value stock is likely to prove rewarding.
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Cached on June 19, 2013, 3:05 pm