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Shopping for stocks? How to avoid a dud Add to ...

Heard about those value investments that turned into value traps? Jason Castelli has a good example.

“Peabody Energy was once the largest coal producer in the United States. It was a classic value trap,” says Mr. Castelli, vice-president and portfolio manager at Raymond James Ltd. in Toronto.

“It attracted value investors for a number of years prior to the company’s bankruptcy in April. Investors failed to realize the structural shift that was occurring in the energy market away from coal to natural gas and renewable power generation,” he says.

A value trap is an investment that, for a while, looks too good to be true. A value trap is a stock that appears to be cheap because it is trading at low multiples, but the company is actually in trouble and the price may never recover.

“Value investing is faith-based investing,” says George Christison, an investment planner and founder of IFM Planning Services and investingforme.com, based in Lantzville, B.C.

“Value investors tend to believe they have the skill, insight and ability to spot opportunities where most can’t. But I think it takes a special personality to value-invest and achieve consistent success,” Mr. Christison says.

But even skilled value investors can be fooled. The nature of value investing is such that prospective buyers look beyond a company’s balance sheet, seeking signs of hidden virtue in a stock that other analysts might consider to be a dog. Sometimes these investors are right and their hunches pay off.

But as those who bet on Peabody Energy likely realize, a hunch can be spectacularly wrong. “Value traps are stocks that are inexpensive for a reason – often something has fundamentally changed, either with the company or the industry it operates in,” Mr. Castelli explains.

How can investors avoid being drawn into value traps? Here are seven questions to ask:

1. What’s the story?

A value investment should have a compelling background story, something promising about the company, its product or its sector that others might be overlooking, Mr. Christison says. “What are Bay Street and Wall Street saying about the company? Why are they down on it? Is the story about a short-term bump in the road or is it more permanent? Does the negative narrative make sense? Does common sense say the story will improve?”

In the Peabody Energy case, “investors failed to read the tea leaves,” Mr. Castelli says. The vast abundance of cheap shale natural gas, a significant shift in environmental policy and a complete collapse in coal prices were clear signs something was afoot.

2. Why so cheap?

Legitimate value stocks will reward investors by rising over time. “But you need to try to understand why the market has devalued the stock,” says Neville Joanes, portfolio manager and chief compliance officer at B.C.-based WealthBar Financial Services Inc.

You need an in-depth understanding of the company, the sector and its competitors, and you need to build a buffer, or room for error, into your valuation, he says.

3. What’s the business model?

Companies that are well managed and have solid histories may run aground thanks to disruption. Their products or services may suddenly become threatened by competitors or made obsolete. Think of travel agencies, taxi fleets or the makers of pocket video cameras just before smartphones came out.

Nimble companies can adjust by offering new services, moving online and so on, but investors should look at the company’s plans for dealing with the disruption.

4. What’s the timeline?

How long will it take for a value investment to be valuable? Many down-and-out companies come back from the brink of doom and do spectacularly well – think Apple Inc. But does the company’s recovery timeline look like months, years or forever? A good look at the sector and how the stock might fare in the general economy should offer practical clues.

5. What’s the price/earnings (P/E) ratio?

The price of a stock should bear a reasonable relationship to the earnings the company is paying to shareholders. If the price is low and the earnings are relatively high, the stock may be a value bargain, but if the relationship looks unreasonable, this is a clue that something might be wrong and the stock could be a value trap.

6. How much debt?

Companies borrow to expand and flourish, but is the target company’s debt so high that it exceeds the debt-to-equity (D/E) ratios that are average for its industry? If a company is out of sync it’s often a warning sign to stay away.

7. How does the value stock fit in the general economy?

“The global economy is stuck in a period of subpar growth,” Mr. Castelli says. “This suggests that investors should continue to gravitate toward growth-style investments rather than value.”

Mr. Joanes says investors can protect themselves by buying safer “buffer” investments that will soften the effect of a value stock that turns out to be a trap.

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