Many shares look incredibly cheap in this vicious bear market. But investors still need to be careful to avoid being burnt even more. Simple is best.
History's greatest investor, Warren Buffett, has two simple rules.
- Rule #1: Never lose money.
- Rule #2: Never forget rule #1.
A Big, Sarcastic Thank-you, Warren!
Sure, practically everyone has lost money in this market -- including Buffett. But take it easy on the Oracle of Omaha here, because he's dead-right. Buffett's intense focus on not just investing in great opportunities but avoiding terrible ones has been the key to epic success.
Avoiding soul-sucking investments -- what we investing nerds dub "value traps" -- is hardly rocket science. Yet, incredibly, I see investors new and old alike make the same mistakes over and over again, breaking Buffett's rules and walking right into what seem like obvious value traps.
Having spent way too much time thinking about it, I've concluded that there are five primary categories of these dreaded mistakes. Avoiding these five traps will save you time, money, and more than a little heartache.
1. The Quarter-life Crisis
These are a real heartbreaker. You find a dominant company whose once sky-high growth has stalled, and its shares along with it. "TechWidget Group is trading at only 15 times earnings right now, only half its five-year average!" you say. "Its earnings have doubled over the past five years, but the shares are down over the same time period. Sounds like a steal!"
Snap! You just walked into a value trap.
Investors falsely believe that names like CSR (LSE: CSR) or Carphone Warehouse (LSE: CPW) will see their relative valuations return to their headier days. They won't.
Why? Captain Obvious would say that growth has slowed and competition has emerged. Also, such companies have been chasing growth through overexpansion and high-profile acquisitions, both strategies which generally destroy rather than create shareholder value.
Steer clear of former telecoms and technology titans.
2. The soaring cyclical
The valuations of cyclical shares are counterintuitive. They always look the cheapest when they've reached their priciest, and look priciest when they're reached their cheapest.
Take nearly any mining company from last year as an example. Vedanta Resources (LSE: VED) looked dirt cheap via a crude, price to earnings ratio (P/E) valuation -- their average P/E last year was just 5.5. But savvy investors know that cyclical companies' profits mean-revert, which is why cyclical stocks' P/E multiples stay low during booms and high during busts.
In other words, you should be looking at cyclical stocks as their P/Es expand, not shrink.
3. The small-cap trap
The six-year small-cap bull run that came crashing to a halt last year was a painful reminder of the small-cap value trap.
The share prices of many small-caps you'd never heard of were flying higher, some for no apparent reason, or worse, on hope rather than substance. Valuations reached for the sky.
Finding a long-run compounding machine within the small-cap space is like finding a needle in a haystack. Show me a company with a long, proven history of creating serious shareholder value, and I'll show you a mid- or large-cap stock.
4. The too-high yielder
A company usually has a high yield (think above 7%) for one of three reasons:
- It has limited growth potential, so managers return as much cash as they can to shareholders (think utilities).
- The company is in a clear state of decline and investors expect a dividend cut (think newspapers).
- The market thinks the dividend is soon to be cut, and/or is unsustainably high (think life insurance).
Broadly speaking, a high payout is a good thing. There's a fine line, though. At The Motley Fool's Champion Shares, we're looking for that sweet spot where an attractive dividend payout is both sustainable and growing.
For example, take one of Champion Shares' recent recommendations, IG Group (LSE: IGG). The shares' trailing dividend yield of 5.8% is exceptional, especially when you consider base interest rates are just 0.5%. On top of that, analysts are currently expecting profits and dividends to keep growing for at least in the next 2 years. That's low-hanging fruit for the income-loving investor.
5. The unopened book
I can already see the Ben Graham fanatics gearing up to peg me with tomatoes, but hear me out. Book values need to be adjusted -- especially heading into and during recessions.
Acquisition-happy companies inevitably end up slashing the goodwill they'd booked while making bloated acquisitions in the years previous. The book values of asset-centric plays (homebuilders, natural resource producers, etc.) also need a good tweaking to reflect the depressed values of those assets. And banks, well, what can I say? Just ask any Royal Bank of Scotland (LSE: RBS) or Lloyds Banking Group (LSE: LLOY) investor about the ease of assessing their balance sheets.
Don't get me wrong: I'm all for buying shares on the cheap. But there's a catch: I'm only interested in good values if they also happen to be great businesses, companies with years of exceptional performance behind and ahead of them. And, of course, ones that pay me to wait for my thesis to play out.
Wrapping the traps
To recap, you can smooth and improve your returns if you:
1. Avoid the stalled-out growth stock undergoing a quarter-life crisis.
2. Steer clear of hot small-caps with blah track records.
3. Don't get tripped up by seemingly cheap soaring cyclicals.
4. Think twice about the yield that looks too good to be true.
5. Don't lean on inflated or unadjusted book values.
You've probably picked up on an underlying theme here: You need unconventionally conventional thinking if you want low-stress success in the stock market.
Looking for great, simple-to-understand businesses at good prices is the easiest way to avoid stepping into a value trap -- and bag great returns besides.
More on the economy and the markets:
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> This article was first published on Fool.com. It has been updated.
> Of the companies mentioned in this article, Bruce Jackson has a beneficial interest in Lloyds Banking Group, proving he is not immune to falling for value traps, the klutz.
