Don't Get Caught in a Value Trap

In your column a few weeks ago about Benjamin Graham's Stock-Picking Strategies, you warned about cheap stocks you labeled "value traps." What are value traps, and how do investors avoid them?

Easier said than done. Value traps -- cheap stocks that turn out to be stinkers -- are like mirages: You think you've found a bargain-priced oasis only to end up eating sand. "It's a real pitfall for value managers," says Peter Morris, manager of Homestead Value fund, which invests in beaten-down companies. "There's no formula to help you steer clear of value traps."

Often stocks that trade at low price-earnings ratios or similar measures of value are cheap for good reason. Investors need to figure out whether the malaise affecting a company is a temporary setback or the start of a death spiral.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just ~~$107.88~~ $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

https://cdn.mos.cms.futurecdn.net/flexiimages/y99mlvgqmn1763972420.png

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

In the late 1990s, Morris thought shares of Oneida, a maker of china and flatware, were a steal because of the company's low stock price and popular brand name. But global competition and a bloated infrastructure wrecked Oneida's finances, and the company filed for bankruptcy in 2006. Warnings signs of a value trap "don't appear all at once," says Morris. "It's a slow, deteriorating process."

Stick with companies that have a sustainable product or service, Morris advises -- ideally, those whose true value has been misjudged by investors. And you want to avoid companies in moribund industries or those with declining market share. Also, a business with little or no debt that generates plenty of cash is less likely to be a value trap than one with a weak balance sheet.

As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.