Three tips to help investors steer clear of value traps

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John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.

If you are a value investor – that is, someone who buys stocks that are trading at low levels compared with earnings, sales, book value or any other fundamental measure – you surely have been caught in a "value trap" at one point or another. These are stocks that look cheap because their fundamentals don't reflect the true state of their businesses. Investors see that they have a low price-to-earnings or price-to-book ratio and snatch them up, only to later realize that the company's earnings or book value was a mirage.

A great example of a value trap: financial stocks in 2008 and 2009. As financials tumbled during the first several months of 2008, many value investors – including legendary Legg Mason fund manager Bill Miller – loaded up on these low-P/E, low-P/B shares. The problem: Financials had been binging on mortgage-backed securities and other debt that boosted their results for a while, but ultimately proved nearly worthless. As companies started taking huge writedowns, it became clear that those low-P/E and low-P/B ratios were based on bloated earnings and book values, meaning the stocks weren't so cheap after all – and they kept falling. Mr. Miller, who had beaten the S&P 500 for a record 15 consecutive years, saw all of his outperformance wiped out.

So, how do you avoid value traps? It's a tricky business, and perhaps most tricky in situations like the financial crisis. Those financial stock value traps were created by assets that were misleadingly valued both on and (to make things more complicated) off companies' balance sheets. Unless you have an extremely in-depth knowledge of an industry, such value traps are difficult to avoid. The same can be said of the many recent oil industry value traps, which resulted from an unexpected collapse in oil prices that hadn't been reflected in companies' fundamentals. The best way to protect against these traps is to make sure that you don't get too heavily concentrated in a few stocks or specific industry. That's what Mr. Miller failed to do in 2008 and 2009.

There is another key step you can take to protect from other kinds of value traps: Use multiple valuation metrics.

Yes, using a single valuation metric can lead to outperformance over the long haul. But for a given stock at a given time, a single valuation metric can be very misleading. For example, a company whose sales have been declining may still be squeezing more and more earnings out of those sales by delaying needed capital improvements or making some crafty accounting manoeuvres. In such cases, the company's P/E ratio is likely to be artificially low, and its price-to-sales (P/S) ratio may be a better gauge of true value.

Similarly, companies can use dangerous amounts of debt that boost earnings and sales in the short term, but make for serious long-term headwinds that will detract from future earnings.

In such cases, both a P/E and P/S ratio could be distorted. In those situations, the EBIT/enterprise value metric made popular by star manager Joel Greenblatt will give a better sense of the stock's true valuation. (This divides a company's earnings before interest and taxes by its enterprise value, which includes not only its market capitalization but also its debt.)

Finally, companies in different industries can be primarily valued using one metric rather than another. Financials and industrials, for example, are more likely to be assessed using their book values, making the P/B ratio a more relevant metric for them than it is for, say, technology companies.

By using multiple valuation metrics within your investment strategy, you make it less likely that you will walk into a value trap.

A stock doesn't have to look cheap using every value metric – you simply aren't going to find many technology companies with low P/B ratios – but it should look cheap using more than one.

My Guru Strategies are based on approaches of history's greatest investors, including Mr. Greenblatt. They use a variety of different valuation metrics. Here's a sampling of some stocks they like that are passing multiple valuation tests.

Cal-Maine Foods Inc. (CALM-Nasdaq): This U.S. egg producer ($2.3-billion U.S. market cap) gets high marks from my Greenblatt-based approach, in part because of its 25.3-per-cent EBIT/enterprise value ratio. It also gets strong interest from the model I base on mutual fund legend Peter Lynch's approach, which likes its 22-per-cent long-term earnings per share growth rate and 6.6 P/E ratio. The firm is also cheap based on cash flow, with a free cash flow yield of 11.1 per cent.

Linamar Corp. (LNR-TSX): This Ontario-based vehicle parts manufacturer makes precision power train systems solutions. It's a rarity in that it gets approval from four of my models. My Greenblatt-based approach likes its 14.3-per-cent EBIT/enterprise value ratio; my Kenneth Fisher- and James O'Shaughnessy-based models like its 0.7 P/S ratio; and my Lynch approach likes its 8.8 P/E ratio.

TrueBlue Inc. (TBI-NYSE): Tacoma, Wash.-based TrueBlue provides temporary blue-collar staffing services to a variety of industries in the United States and Canada. The $900-million-market-cap firm gets strong interest from my Lynch- and O'Shaughnessy-based models, thanks in part to its 0.35 P/S ratio and 12.8 P/E. It also has a solid 9.7-per-cent EBIT/enterprise value ratio and 9.9-per-cent free cash flow yield.

The writer is long CALM and TBI.

John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.

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Editor's note: An earlier version of this story incorrectly stated TrueBlue's market cap at $900-billion. The correct figure is $900-million.