How to Avoid Value Traps

by Tim Melvin | September 13, 2013 8:59 am

One of the potential pitfalls is falling into what is known as a “value trap.” This is a stock that is cheap based on assets and earnings, but one that never actually improves, as one expects a good value stock to eventually do. Instead, the stock stays cheap for an extended period of time as business conditions never improve or management just simply fails to execute.

A value trap can keep your money tied up in unproductive assets for an extended period of time. Avoiding them is an absolute must if your goal is to consistently earn positive returns and beat the market over time.

One way to avoid value traps was developed by Professor Joseph Piotroski of the Stanford University Graduate School of Business. When he was an associate professor at the university of Chicago, he wrote a paper titled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers.”[1] In it, he introduced the F-score — a 9-point examination of the financial statements that helped identify potential winning value stocks from value traps. The higher the F-score, the better the chance the stock would be a winner over the next few years.

By focusing on those stocks trading below book value with high F-scores, investors should be able to avoid value traps and drastically improve their long-term performance.

I ran a quick screen this morning to search for stocks that trade below book value and have high F-scores. One intriguing name on the list is Stratus Properties (STRS[2]). The company engages in the real estate development and management business primarily in Austin, Texas. It also operates The W Austin Hotel & Residences project in downtown Austin, which includes Austin City Limits Live, a premier music venue.

I am intrigued by this because it is surprisingly cheap for a real estate company operating in the booming Austin area. Business seems to be good for the company, as revenues and operating profits are up aggressively year-over-year and the bottom line has gone from red to black in the past year.

Stratus CEO William H. Armstrong recently said, “The Austin real estate market is strong, and our assets are performing well. We also are pursuing beneficial refinancing opportunities made possible by our business performance and the current interest rate environment.”

Importantly here, STRS shares trade at 80% of tangible book value and have an F-score of 8, so the stock does not appear to be a value trap.

Investors with an interest in benefiting from the boom town of Austin might want to give these shares a closer look. However, if you’re interested in looking elsewhere, keep this screening mix of book value and F-score at the ready.

As of this writing, Tim Melvin did not hold a position in any of the aforementioned securities.

  1. “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers.”:
  2. STRS:

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