How to identify and avoid value traps

Today, I want to warn you about one of the most insidious errors long-term investors can make...

I'm talking about falling for value traps.

These are stocks that appear cheap but nevertheless continue to decline along with the underlying business.

As such, it's a critically important skill to be able to identify and avoid such traps.

Sure, it's possible to make money buying the stocks of dying businesses like check printers, paging companies, and the like. But in general, it's extremely difficult to make money on a stock, no matter how cheap it is, if the business's fundamentals steadily decline.

Just look at Bed Bath & Beyond with the below slide from my presentation on my "make money" investing approach. I warned about the retailer in 2018 when its stock had declined from $80 per share to $15 per share.

The apparent cheapness of the stock sucked in value investors, who were incinerated as Bed Bath & Beyond continued to decline and eventually went bankrupt:

There are plenty of case studies of dying retailers. Below are stock and earnings charts from my presentation for Barnes & Noble and Sears:

This next slide shows 3D Systems (DDD), which soared during the 3D-printing bubble in 2012 and 2013 and eventually hit around $100 per share... and then it collapsed:

Today, DDD shares sit at less than $5.

So how do you avoid value traps?

It's simple in concept – just avoid businesses in secular decline – but difficult in practice. Even the most obviously dying businesses always have a plausible-sounding turnaround plan... and, boy, does the stock look cheap!

It's so easy to tell yourself something like:

I know the business is hurting, but the new CEO has an impressive track record.

If they can merely stabilize the business, the stock could be a double... and if they can actually turn it around and start growing revenues and earnings, the stock could be a five- to 10-bagger.

It's not crazy to think this because even the greatest businesses usually go through periods when earnings decline for at least a quarter or two, generally accompanied by grim headlines.

I remember when the stock of McDonald's (MCD) had declined from nearly $50 per share to less than $13 per share in early 2003, and CNBC pundit Jim Cramer called it "unownable."

I also remember when Netflix (NFLX) crashed from $43 per share to less than $8 per share in October 2012 in the wake of the Qwikster DVD-by-mail debacle.

Both, of course, turned into rocket ships – take a look at these long-term charts:

So, again, how do you distinguish between garbage like Bed Bath & Beyond and 3D Systems, versus extraordinary turnarounds like McDonald's and Netflix?

I wish I could give you an easy answer, but there isn't one. It requires experience, judgment, and rationality to separate the wheat from the chaff.

Pattern recognition is important. So in my next e-mails, I'll share some examples of stocks that looked like – and, for a time, were – value traps but turned around and became some of the greatest stocks of all time... so stay tuned!

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.