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How to Avoid Value Traps

We’ve seen them all before. A stock that has a really cheap price relative to earnings, or cash flow, or book value. Maybe the stock is trading at a 52-week low. By buying the stock, there’s a certain feeling of satisfaction, a feeling that you’re outsmarting everyone else, that you’re “being greedy when others are fearful”, just like Warren Buffett always says.

Then you discover that the stock was cheap for a reason. Or, to put it another way, it wasn’t so cheap after all. This is commonly referred to as “trying to catch a fallen knife”.

So how do you avoid these traps? Below are three tips.

1. Look for a strong track record

Often the best ideas come when a company has a long history of growing earnings and investing capital wisely, but then has a few bad quarters. There is a big difference between these companies and the ones that consistently underperform.

For example, SNC Lavalin (TSX: SNC) has been one of Canada’s premier construction companies for a long time, rewarding long-term shareholders handsomely. From early 2001 to early 2011, the shares increased by more than a factor of 10. But then a corruption scandal surfaced in late February 2011, and the stock plunged more than 20% in one day.

There ended up being a lot more to the story, with resignations, arrests, and other corruption scandals surfacing. The stock moved nowhere until December 2012. But SNC remained one of Canada’s top engineering firms, and the stock eventually did recover; the shares have increased 40% since then.

2. Avoid disruption targets

It is well known that investors tend to overreact to short-term issues. This can create an opportunity to pick up a cheap stock, like SNC Lavalin. But a stock can also be cheap because there are legitimate concerns about the company’s competitive position. Maybe the industry is more competitive, or there are cheaper alternatives. Or maybe there is less of a need for the company’s products, because of a newer alternative. This is often called a “disruption” story.

In this second type of situation, stocks often decline slowly, meaning if you think you’re buying a cheap stock, it may still be too expensive. A good example of this is Torstar (TSX: TS.B), owner of the Toronto Star newspaper and – until last Friday – Harlequin romance novels. These businesses are in natural decline, and digital media is not enough to make up the difference.

Did this create an opportunity for value investors to buy a cheap stock? Well, in April 2011 the company traded at $15 per share. Then it declined, and bottomed out around $5 in February 2014. In other words, it took almost three years for the stock to fall all the way – and on the way down it looked cheap to a lot of value investors. But in situations like these, it can take a while for a company’s underlying problems to fully present themselves.

3. Avoid the high dividend yields!

Here’s a good rule of thumb: if a stock yields over 8%, don’t buy it. These companies are especially dangerous, often because they pay out more in dividends than they make in income. And they often fall into category number 2 as well. A good example of this is AGF Management (TSX: AGF.B), which is struggling with poor fund performance, departing employees, and declining assets. These types of bets are not worth making.

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Fool contributor Benjamin Sinclair holds no positions in any of the stocks mentioned in this article.

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