Cheap stocks: beware the trap

Cheap stocks: beware the trap

Many investors are now looking for bargains in the stock market; value investing is gaining more and more fans - but do they perform fundamental analysis to avoid value traps?

The economy is on the brink of recession, or in a recession already; the Fed is determined to cool down inflation, risking to over-correct and send the economy into a hard landing. The consumers are feeling the pain: the sentiment is as low as it gets, and that pessimism is translating into a decline in retail spending. Analysts are slow to adjust their projections for corporate profits, but there’s little doubt that companies’ bottom lines will show a downturn.

Time to cut your stock market losses — or not?

As the market gyrates around the downward line, stock traders that were the biggest market winners in 2021 are furiously rushing to the exits. If in the beginning of the declines of 2022 the main retail investment theme was “buy the dip”, now it’s “sell on upticks”. That’s because “strategies” that worked last year, failed spectacularly in 2022: Goldman’s basket of retail-favored stocks has lost more than 40% year to date, while an “index” of companies most frequently mentioned on social-media platforms is down 50%. So now, according to Goldman Sachs, retail investors have sold most of their US stock purchases from the last two years. A retail-investor behavior measure by TD Ameritrade shows they have been cutting exposure to equities this year.

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The long and hard way from meme-trading to value investing

All types of investments have lost value in 2022; however the pain is much more acute for short-term traders, who bought on hype and now sell on volatility, locking in massive losses. No wonder that many of them are now looking up terms like “value investing” in Google. Their intentions are getting backed up by none other than the US Securities and Exchange Commission, who is now trying to encourage them to research before investing

However, for many traders, “doing research” on a stock means checking its price versus history, plus maybe looking at some technical indicators. When they see that the stock they’ve heard about on social media or from influencers trades way below levels seen last year, they believe that they’ve found a “value play”. What they actually do is not value investing, but buying the dip in previously super-expensive, hyped-up stocks.

Of course, the fact that a stock was hyped up on Reddit and surged hundreds of percent in 2021 (like GameStop, AMC and others) doesn’t necessarily mean it is not a good investment: maybe it is worth the much cheaper price at which it’s trading now… or maybe it isn’t; valuation alone can’t provide a good answer, as it’s often misleading. 

The dangers of cheap valuations

The problem with the valuation approach is the danger of a “value trap”. Value trap is a situation in which a stock that trades at a much cheaper valuation than its peers and/or its own price history, may attract bargain hunters, but the low price and low multiples may mean the company is experiencing financial instability and has little growth potential, and the stock may continue to languish or drop further. 

Companies that have been trading at low multiples of earnings, cash flow, or book value for an extended period of time are sometimes doing so for good reason: because they have little promise, and possibly no future. 

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Buying ETFs won’t help in this market

For some traders, abandoning meme-stocks and crypto assets doesn’t necessarily translate into becoming Warren Buffet-types of investors. According to Goldman Sachs, retail investors are continuing to put money toward ETFs, especially defensive and dividend-focused ones, which have seen more than $30 billion of inflows this year.

Investors may think that the answer to avoiding value traps is to skip on individual stocks entirely as they lack the financial, accounting, and managerial skills that are needed to evaluate specific firms, and to buy index funds and ETFs instead. However, as we have established, now it’s probably one of the worst periods in recent decades to rely on passive funds. These passive instruments hold a wide range of stocks in accordance to indexes they follow, indiscriminately pulling together stocks of great companies with those of much weaker ones. This bear market will end, of course, as do all bear markets, but not all companies will survive, and not all stocks will rebound. Who knows, how many of these non-viable stocks are on your ETF’s holding list?

But reading the fundamentals can help find treasure

Instead, it’s advisable to try and discover all the “why’s” of the stock behavior, which means reading the news, the press-releases and - yes, it’s necessary - the financial reports. If you do your homework, in some cases you'll come upon a gem: a wonderful business that is being practically given away for free.  

To be clear, valuation is of no use whatever in making a timing decision. A cheap market can always get cheaper. But it’s critical to choosing which stocks offer compelling returns over the longer term. This can be simply broken down into two components — the earnings you expect a company to make in the future, and the multiple of those earnings that investors are prepared to pay to buy the stock.

Searching for bargains, look for quality

So what should investors do: buy the dip? sell on upticks? - no, research and buy the quality at reasonable prices, avoiding the value traps by looking into the companies financial metrics. 

Here are two examples of stocks considered potential value traps by our immensely genius, inhumanly unbiased and totally hype-free Artificial Intelligence analyst:

Crocs, Inc. (CROX)

The company went public with $21.00 in its Feb 8, 2006 IPO. Since then, the stock had its ups and downs, but then the trading mania of Covid-19 era made it surge up to $184 in November last year. Now that it’s trading at $53 and with a P/E of 3.1 (versus 10.6 industry average and its own history of double or even triple-digit multiples); many analysts declare it “a rare opportunity”. Of course, value traps are only seen in hindsight, but “if it quacks like a duck…” In any case, our AI has declared the company’s stock UNDERPERFORM after Q1 2022 financial results (in the previous quarters it was still a HOLD). That is because the financials published by Crocs for Q1 were weak and discouraging. Its growth and income factors performance indicated that company management is missing key targets and not executing well in areas that matter most. These troubling results make a strong case for underperformance and for anticipating a significant downside. 

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Paramount Global (PARA)

This stock may be another value trap, although at a first glance it might look counterintuitive: how does a company with a market cap of 16.82B that is well known to media consumers in the Americas and in the UK become a hopeless waste of investment? Well, numbers don’t lie: in Q1 2022 the company released a weak financial report that led our AI analyst to give it an UNDERPERFORM rating. In the previous quarter things were looking up a bit for PARA, but the improvement wasn’t sustainable, apparently. The stock trades now at a P/E of 4.2 (versus the industry average of 13.1), and its multiples have been constantly declining since 2018 when the TTM P/E hit its high of 205 (at the time the company traded under a different name). The stock’s price is around $25 now, close to its average, and PARA’s troubling financial results make a strong case for underperformance in the next quarters, as well as for anticipating a significant downside down the road.

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When contemplating value investment, our AI analyst suggests that these two now-cheap plays are worth a close look:

Texas Instruments Incorporated (TXN)

Texas Instruments has existed since 1930, one of the oldest surviving corporations in the US. The stock’s long history shows almost continuous growth in the last decades, except for a little bubble and a consequent drop in 2000. The stock reached its latest high of $201 in October 2021 and has been on decline since then with most of the US market. With a price of $155 and a P/E of 17.8 (versus the industry average of 22.5 and close to its own long-term average), the stock looks like a value buy, especially taking into account its high dividend of 2.95%, almost twice the industry average. Looking into TXN’s fundamentals, our AI saw several impressive financial metrics that should make them more attractive than their peers going forward. The stock is rated a BUY and not a STRONG BUY as it faces a stiff competition, with many financially sound and stable companies in its industry:

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Sanderson Farms Inc. (SAFM)

The company is rated STRONG BUY by our AI; it has maintained this rating since 2020. Although the stock is now at its all-time high of $214, its P/E ratio stands at a mere 5.6 versus the industry average of 26.4. The company pays low but stable dividends; its financial health suggests that these may grow in the future. SAFM is one of a very few public companies that is completely debt free, so that it can use its income as it sees appropriate. 

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As you can see, at the stock picking level, the only way to avoid a value trap is by doing your homework. Valuation is just one aspect of what makes a good investment, and the cheapest stocks don’t necessarily make the best investments. It’s therefore necessary to dive into fundamentals of the potential investment in order to establish whether the stock is selling below its intrinsic value, or the price is low because the value of the investment is low. 

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