Some stocks are cheap for a reason. Of course, as an investor, you hope that tromping through the woods will yield a cheap but tasty stock that has gone overlooked by the other hunters and will yield you a fortune. But sometimes you think you’ve found a bargain only to find that you’ve stepped on a trip wire and now have steel jaws clamped on your leg! Ouch — that’s a value trap.
One such trap is GameStop Corporation (NYSE:GME). Common sense would suggest that with all the young folk out there staring at their wide-screen TV’s with Xbox’s in hand that the gaming industry is making a fortune. Well, gaming manufacturers are, but retailers aren’t. The company just reported a 1.5% same-store sales decline for Q4. The stock trades at a P/E of 8, which is why it’ll show up on value screens. But the point of a value stock is that its growth rate exceeds its P/E, giving a PEG ratio that’s quite a bit under 1.0. The problem is that the trend for gaming retailers is flat to down and not big-time growth. So while the company is hardly about to go bankrupt, it isn’t a value, either.
ITT Corporation (NYSE:ITT) might normally attract me because it’s a boring company in a boring industry. Yet its business has been very inconsistent, with revenue and earnings behaving in roller-coaster fashion. Yes, it trades at an attractive 12 times earnings, with solid gross and net margins, good cash flow, and net cash of $1 billion. Yet it’s hard to tell if the company is growing given the aforementioned roller-coaster financials. That’s another thing you want to look for in a low-P/E stock — is the P/E low because this year’s earnings are making it attractive, while next year’s may take a hit? Think of this as looking under the brush before taking a step.
Did you find some old newsprint in the forest? It wouldn’t surprise me. Sometimes a value trap can be an entire industry, and thus, newspapers are not the place to invest. That’s why I think of Gannett Co. (NYSE:GCI) as another type of value trap. The company trades at a mere 7 on the P/E scale, yet analysts forecast only 6% earnings growth annually over the next five years. And the way I see it, that’s an overestimate. Newspapers are so 20th century. We are all getting our news online and via mobile devices. That trend is only going to continue. I wouldn’t pay seven times earnings for a horse-and-buggy company. Would you?
Our final trap is the classic Bank of America (NYSE:BAC). This type of value trap occurs when you have a financial stock, particularly a bank, for which P/E ratios don’t really matter. They matter even less when you have a company with zillions of dollars of toxic mortgages and no real way to value them. Again, this type of company will show up on a value screen because it trades at a P/E of 7. Some would say that if Warren Buffett puts $5 billion into a company, that’s reason enough to buy. I say, why is he putting $5 billion into a business if it wasn’t healthy to begin with just to shore up a bad balance sheet. Stay away!
If you really want to find bargains, I suggest you hunt for nonfinancial stocks with PEG ratios under 0.66. That gives you a huge margin of error with respect to valuation, providing a better chance that you’ll find a delicious truffle in the forest — and not end up in the ER.
Lawrence Meyers does not own shares of any company mentioned here.
