Don't Get Burned By Cheap Stocks

If you have ever purchased a dirt-cheap stock only to watch it grow cheaper -- and cheaper and cheaper -- you can at least take comfort knowing you're in good company. At one point or another, says Josh Strauss, co-manager of the Appleseed Fund, "all value managers fall into value traps." What he means is that sometimes beaten-up stocks continue to fall or never recover. Any value manager who claims otherwise is lying, says Strauss.

Value traps typically come in two varieties. One is a product of high leverage -- that is, a high level of debt in the company's capital structure. Leverage acts like a magnifying glass on a firm's underlying business, heightening the impact of ups and downs on profits. "Your margin of safety on a highly leveraged company may be smaller than it seems," says Matthew McLennan, co-manager of First Eagle U.S. Value Fund.

The leverage trap ensnared many value managers in early 2008, when beaten-down financial stocks, such as Fannie Mae, Wachovia and Citigroup (symbol C), appeared too cheap to ignore. Because the core business of banks is to take deposits and make loans (or, in Fannie Mae's case, to issue debt and purchase mortgages), high leverage is a fact of life for the industry. But as the value of the loans held by many financial companies continued to deteriorate -- leading to huge losses and crushing the firms' book values (assets minus liabilities) -- the stocks descended into oblivion. Ultimately, shareholders in Fannie and Wachovia were all but wiped out, and Citi owners took a terrible beating.

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The other variety of value trap snaps shut when a company's core business heads out of style or into obsolescence, and management reacts too late to prevent a downslide. For example, Eastman Kodak (EK) used to make tidy profits selling film. But the company was slow to embrace technological change as consumers rapidly adopted digital cameras. Despite numerous attempts to restructure and create a niche for itself in the digital age, Kodak's results have lagged. The stock peaked in 1997 at $93; on October 8, it closed at $4. Among those who fell into the Kodak trap is Bill Miller, Legg Mason's renowned value manager. He started buying the stock in 2000 for his mutual funds, and today they are Kodak's largest shareholders.

Where might value traps lurk today? Shares of Microsoft (MSFT), which have returned zip over the past decade, are flirting with value-trap status. However, as Strauss points out, the stock's price-earnings ratio has descended over the period from astronomical heights (as the share price dropped) while Microsoft's results, unlike those of Kodak, steadily improved. Still, some investors worry that competitive threats, such as Google's move into software and the growing availability of computer applications on smart phones, will eventually erode Microsoft's core businesses and further the stock's long-term decline (see our take on Microsoft's prospects).

Value traps are easy to spot in hindsight. But with a little foresight, you can mitigate their impact on your portfolio. "If you acknowledge that a certain number of your investments will be unsuccessful, then it makes sense to limit your exposure to any one investment," says McLennan. In other words, don't bet the farm on a single stock. Following this rule will also help you avoid the temptation to increase your stake when a dud you own becomes even cheaper. Holding smaller stakes will grant you the "mental flexibility" to admit your mistake and move on, says McLennan.