One of the most difficult — and most important — aspects of value investors is determining whether a “cheap” stock is a value play … or a value trap. Stocks with low earnings multiples or trading below book value could be opportunities the market is missing. Or those multiples could be warnings from the market that these companies should be avoided (or in some cases, are stocks to sell like they’re radioactive).
Like everything else in investing, it’s not an exact science. But value traps generally offer declining sales and/or earnings, while also facing company- or industry-specific headwinds likely to accelerate those declines.
U.S. brick-and-mortar retail has been a prime of example of late. Low multiples there in most cases weren’t a buying opportunity. Rather, they were the result of a realization by investors that e-commerce competition led by Amazon.com, Inc. (NASDAQ:AMZN), along with other factors, was likely to send earnings — and share prices — sharply lower.
Retail still has a few value traps, and so do many other sectors. Here are 10 of those value traps, which at best should simply be avoided, but at worst are stocks to sell in a heartbeat.
Value Traps to Avoid: Mattel (MAT)
The contrarian case for Mattel, Inc. (NYSE:MAT) seems reasonably easy to make. MAT stock has declined by more than 50% just since 2014, and now trades at a seemingly low 17 times 2018 analyst earnings-per-share estimates.
Mattel, which recently slashed its dividend, still offers a payout that yields nearly 3%. It owns iconic brands like Barbie, American Girl, Fisher-Price, Hot Wheels and Matchbox. And it’s not as if its industry is in terminal decline. Peer Hasbro, Inc. (NASDAQ:HAS) has seen its stock better than triple over the past five years.
A new CEO — hired from Alphabet Inc (NASDAQ:GOOGL) — has put together a turnaround plan, and the balance sheet is in decent shape.
But the fact is that MAT remains a stock to avoid, at the very least.
Mattel’s key brands haven’t been that bad. Barbie revenue grew 7% in 2016, per the Mattel 10-K. The car brands grew 6%, and the Entertainment business 13%. The problem has been in the lesser-known businesses, and with margins. Those problems are much more difficult to fix.
With Mattel shares cheap but not outrageously so — 17x still implies a decent amount of growth going forward — MAT seems to be trading at $21 for good reason.
Value Traps to Avoid: Ford (F) and General Motors (GM)
Two of the most well-covered “value trap versus value play” arguments the past few years have been Ford Motor Company (NYSE:F) and General Motors Company (NYSE:GM). Shares of both iconic carmakers are available at seemingly bargain-basement prices.
Ford stock trades at levels rarely seen over the past five years, and at 7x estimated 2018 earnings. GM is even cheaper — 6 times earnings! — and basically hasn’t moved since its 2010 public offering at $33.
Both stocks are priced as if earnings have peaked for good. That very well may be the case. Both companies are dealing with the potential of “peak auto.” Both appear to lag in electric vehicles, where Tesla Inc (NASDAQ:TSLA) is set to make a major foray with its reasonably-priced, mass-produced Model 3.
At the moment, both F and GM look like stocks to sell outright. Between secular changes in the industry and more near-term problems — such as a glut of used cars and lower demand from fleet operators — both stocks look cheap for very good reasons.
Value Traps to Avoid: DineEquity (DIN)
DineEquity Inc (NYSE:DIN) owns two well-known restaurant concepts: IHOP and Applebee’s. And DIN stock looks cheap after a huge fall.
DineEquity’s shares traded at more than $100 in early 2015; they’re now valued barely above $40. That translates into a current P/E of merely 9, and it yields a whopping 9% to boot! The company is working to turn around the Applebee’s concept, but IHOP is reasonably stable. DineEquity has guided for positive same-restaurant sales in that concept for 2017.
And still, DIN looks like a sucker’s bet at this point.
Applebee’s remains an undifferentiated concept with declining interest. Peers like Brinker International, Inc. (NYSE:EAT), which owns the Chili’s concept, is struggling as well. Aside from Darden Restaurants, Inc. (NYSE:DRI), which is having success with its Olive Garden brand, most restaurant plays look like stocks to avoid at the moment.
DineEquity, meanwhile, is 99% franchised, meaning corporate profits are based on revenue. That was a benefit when sales were rising — and a weight as revenue declines. Add to that a reasonable amount of debt, and DineEquity looks like a value trap.
At the least, it looks like it will get worse for DIN before it gets better.
Value Traps to Avoid: Arris International (ARRS)
The bear case against Arris International plc (NASDAQ:ARRS) has been pretty simple. The company’s key product in set-top boxes for cable operators is under threat. Set-top boxes very well may be phased out over time. And in the meantime, more “cord-cutting” by cable subscribers presents a headwind to revenue. A declining business, per this argument, makes Arris one of the most obvious tech stocks to sell.
The reality is a more nuanced, but not quite enough.
Arris does have some business in cable and telco infrastructure. That business should benefit from data needs surrounding 5G and the Internet of Things (IoT). There’s still a consumer Wi-Fi business which could benefit from similar trends.
With the early 2016 acquisition of Pace only increasing its exposure to STBs, ARRS still looks like it’s in a dangerous spot.
But overall, this still looks like a business that deserves its relatively cheap multiple of about 10x next year’s EPS. The rate of change in tech more broadly means companies that get left behind often seen their stock prices plunge. And beyond set-top boxes, Arris simply doesn’t look that well-positioned.
Value Traps to Avoid: AutoZone (AZO)
At the moment, the three major auto parts suppliers all look like stocks to avoid. And of the three, AutoZone, Inc. (NYSE:AZO) looks like the cheapest — and potentially the most dangerous.
AZO and peers O’Reilly Automotive Inc (NASDAQ:ORLY) and Advance Auto Parts, Inc. (NYSE:AAP) have been hammered of late. Slowing sales have stoked fears of both increased online competition and worries that a newer car fleet simply won’t require the same maintenance seen in past years. Add to that the same long-term worries pressuring Ford and GM — not to mention auto part suppliers — and even the mid-teen multiples in the space still look too aggressive.
AutoZone is the cheapest of the three … but it also has posted the weakest sales numbers of late. With pressure on the sector likely to continue, the pressure may be most intense on the company struggling the most. And that means AZO is a sell — even after a 36% decline so far in 2017.
Value Traps to Avoid: Pitney Bowes (PBI)
Pitney Bowes Inc. (NYSE:PBI) is another long-running “value play or value trap?” debate.
The company’s legacy business of providing equipment for mailing is in clear secular decline. In response, PBI has tried to shift towards software and professional services for e-commerce providers.
Both Pitney bulls and bears have won their share of battles. PBI stock bottomed near $10 in late 2012; it would hit $28 in less than two years. But it’s been almost straight downhill since then, though a nice Q1 earnings beat in May did give shares a reprieve.
That reprieve may be short-lived.
Revenue and non-GAAP earnings for Pitney Bowes are falling, and likely will continue to do so. From that standpoint, a single-digit P/E ratio and a 5% dividend yield look attractive, but not hugely so. Pitney Bowes already halved its dividend back in 2013, and hasn’t raised it since. Expecting any growth in the payout — or earnings — looks optimistic at this point.
With secular issues continuing, along with competition from Stamps.com Inc. (NASDAQ:STMP), Pitney Bowes simply looks like a business in decline. And PBI looks like one of many so-called “cheap” stocks to avoid.
Value Traps to Avoid: GameStop (GME)
For a while, GameStop Corp. (NYSE:GME) looked like a value play. Sales were holding up reasonably well in the legacy video game business, despite a lull in the console cycle. With the Nintendo Co. (OTCMKTS:NTDOY) providing a boost to demand, and new consoles coming from Sony Corp (ADR) (NYSE:SNE) and Microsoft Corporation (NASDAQ:MSFT), there was some hope for renewed earnings growth — and a higher share price for GME.
Full disclosure: I actually owned GME stock last year.
But as InvestorPlace contributor Hilary Kramer argued last month, GameStop can’t ride the Switch forever. And the company’s foray into wireless reselling looks fraught with danger. GameStop has invested billions into its so-called Technology Brands business, just as price competition is pressuring margins for the four major U.S. cellular operators.
At barely 6 times earnings, and with a 7% dividend yield, investors might think GME is worth the risk. But actually GME is another of the long list of retail stocks to sell. Those earnings are declining — and as video game deliveries shift to digital, those declines will accelerate. GameStop’s bet on moving away from video games made sense at the time, but early returns look disappointing.
Without a rebound there, the long drop in GME stock should continue.
Value Traps to Avoid: AT&T (T)
The same competition that is an issue for GameStop’s Technology Brands business is a problem for the cellular operators themselves. And even after an ugly performance in 2017, that pressure isn’t quite priced into AT&T Inc. (NYSE:T) stock.
Aggressive pricing from Sprint Corp (NYSE:S) has forced market leaders AT&T and Verizon Communications Inc. (NYSE:VZ) to follow suit. That in turn hurts margins for both companies. Meanwhile, T-Mobile US Inc (NASDAQ:TMUS) is taking market share, leading AT&T subscribers to actually decline in its first quarter.
At the same time, AT&T has ramped up its debt load, including on the proposed $85 billion purchase of Time Warner Inc (NYSE:TWX). That deal is a big bet, both operationally and financially. And with wireline revenue declining and wireless profits likely stagnant at best, the additional debt required to fund that acquisition may be too much for T stock to bear.
AT&T is a giant of American industry, and it’s not headed for bankruptcy. But the pressure in the space means T should be avoided — and for that matter, Verizon should too.
AT&T’s balance sheet means its earnings, and share price, could be headed further downward.
Value Traps to Avoid: Finish Line (FINL)
As noted above, there are a number of value traps in retail that are stocks to sell. But Finish Line Inc. (NASDAQ:FINL) is one of the most dangerous.
After all, FINL looks reasonably cheap, particularly when considering the nearly $2 per share in cash on the balance sheet. Sneaker sales seem to be holding up well. In fact, key Finish Line supplier Nike Inc (NYSE:NKE) just posted a blowout quarter. Amidst mall-based retailers — all of whom look “cheap” — Finish Line might be considered a diamond in the rough.
But that’s not the case.
Rival Foot Locker, Inc. (NYSE:FL) has seen its stock collapse of late, as revenue there slows. But Foot Locker actually has consistently taken share from Finish Line over the past few years. Nike and Adidas AG (ADR) (OTCMKTS:ADDYY) both are trying to grow their direct-to-consumer businesses, circumventing Finish Line in the process. And Finish Line has had a series of operational errors, including in the rollout of its own e-commerce site.
At roughly 10x forward earnings plus cash, FINL might look cheap. But many retailers — Finish Line included — have looked cheap over the past two years, and nearly all have seen their share prices fall. FINL is likely to be no exception.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.