Don't Get Burned By Cheap Stocks

Value traps can ensnare even the most adept investing pros. But they don't need to wreck your portfolio.

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.

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Elizabeth Leary
Contributing Editor, Kiplinger's Personal Finance
Elizabeth Leary (née Ody) first joined Kiplinger in 2006 as a reporter, and has held various positions on staff and as a contributor in the years since. Her writing has also appeared in Barron's, BloombergBusinessweek, The Washington Post and other outlets.