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 may reveal more insights that take the shine off of any value play.
Here are some key items to watch out for.
1. When losses sink book value. Investors tend to take a shine to stocks that are trading at less than book value (which means that the company's market value is less than shareholder's equity -- found on the bottom of the balance sheet). Trouble is, if that company is losing money, or taking major write-offs, then shareholder's equity is likely to erode. To be safe, look for "below book" stocks that are actually profitable, so shareholder's equity (book value) will keep rising. (For further reading on "below book" stocks, check out this article)
2. Cash flow that never becomes cash. Analysts will often tout certain stocks that appear cheap on the basis of their cash flow. Indeed cash flow can be a very good metric, as it proves that a company can generate ample excess returns from operations. And while a company is growing at fast clip, it makes sense for management to re-invest that cash flow back into the business.
Yet some companies seem perpetually stuck in that mode, always pushing the money into the business in order to keep up with competition. So that cash flow never translates into rising cash levels. For example, solar panel maker SunPower (SPWRA) consistently generates positive operating cash flow, but heavy investments mean that free cash flow is always negative. That has forced the company to repeatedly sell more shares to stay afloat, diluting the stake of existing shareholders.
3. An uncertain dividend yield. Dividend stocks are often seen as value stocks. Their high yields provide an attractive source of income even if their shares have limited capital appreciation potential. But many investors mistakenly buy stocks with unusually high dividend yields. And extremely high yields -- in excess of 10%, for example -- can be a sign that the dividend will need to be cut. At the depths of the economic crisis, media firm Gannett (NYSE:GCI) offered a $1.42 annual dividend, even as its stock moved below $7, implying a dividend yield in excess of 20%. Management soon had 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. The low P/E trap. Stocks with low price-to-earnings (P/E) ratios often represent the best value. But only ifearnings are flat are 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 its 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 futureearnings. 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.
5. Overvalued assets on the balance sheet. This is a twist on the first item noted in this article, that book value should be taken with a grain of salt. Many companies carry assets on their books that don't necessarily relate to actual real world values. Some investors like to cite department store retailer Dillard's (NYSE:DDS) as a compelling value play, as the company is valued at $1.8 billion, but the value of its real estate holdings is $2.7 billion -- +50% higher. Yet it's unreasonable to assume that the company would find any buyers paying full value for its real estate while the world is awash in unused retail space. If the economy sharply improves, and many empty retail stores are re-occupied, then Dillard's would likely get more appreciation for its real estate. But not right now.
Action to Take --> "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.
-- David Sterman
David Sterman started his career in equity research at Smith Barney, culminating in a position as Senior Analyst covering European banks. David has also served as Director of Research at Individual Investor and a Managing Editor at TheStreet.com. Read More...
This article originally appeared on StreetAuthority