All investors look for stocks that are priced below true value. “Buy low, sell high” is good advice in any market, but it is not so easy to follow. The problem is not the buy low part of the equation: seemingly cheap stocks are plentiful. The difficult part is the sell high side of that equation. I’m not talking about timing your profitable sell order; I’m talking about buying low and watching the price sink lower and lower.

How is value measured?

While there is no consensus, there are a number of fundamental indicators an investor can look at to categorize a stock as a “value” stock. One very simple indicator to look at is the price-to-earnings (PE) ratio. Some value index mutual funds simply take the list of all stocks and divide them into two groups based on the mid-point of PE ratios: the lower half being the value stocks, the higher half being the growth stocks. Only an index fund could get away with such a broad definition, though. Some investors prefer other indicators such as price-to-sales, book value, or cash flow; but PE is one of the most commonly used indicators of value. Even if you use a more reasonable approach – say PE within a sector or a historically low PE for the stock while similar stocks are at a historical average – any analysis based on these metrics alone can lead you into a value trap.

What is a value trap?

There may be a good reason a stock is trading at a low multiple; especially if it has been at a low multiple for a long time. These stocks may have beginner value investors thinking terms like “safety,” “undervalued,” and “profits,” but some of these stocks should instead have you thinking “I’ll pass.” Fundamental investors sometime lose sight of the fact that stocks are priced on future earnings, not current or past ratios. If earnings will deteriorate in the future – and there are several reasons why they could – the current stock price may not be a value at all. There are two sides to a ratio. A stock with a low PE ratio can quickly turn into an overpriced stock with a high ratio, but chances are the price of these stocks will drop to keep the ratio from changing too drastically.

A classic example

Warren Buffett bought a controlling interest in a textile company called Berkshire Hathaway based on fundamental analysis. He thought the company would be producing a nice flow of cash for decades to come. A little over 20 years later, the only thing he had left from that purchase is the Berkshire name and a lot of hard earned lessons. To quote Buffett in his 1985 letter to shareholders, the textile business, “had an accounting net worth of $22 million, all devoted to the textile business. The company’s intrinsic business value, however, was considerably less because the textile assets were unable to earn returns commensurate with their accounting value.”

The textile industry had become a commodity business, and Berkshire could not compete in the world market. Future earnings would do nothing but get worse. An investor looking at the PE ratio would think the stock price was cheap when in reality it was too expensive. Would the investor looking at the book value have fared any better? At liquidation, the textile equipment had a book value of $866,000, and Buffett estimated it would have cost $30 – 50 million to replace it. It ended up selling for $163,122. Allowing for costs, the net return of the liquidation was less than nothing.

How to avoid value traps

There is not one standard you can apply in all situations to determine if a stock is a value or a value trap. Instead, ask yourself a few questions about the long term viability of the company, and then do your due diligence to determine if betting on the future of the company is low risk:

Is the company or the sector at risk for becoming obsolete or becoming a commodity? This is not as much of a crystal ball question as it may seem. It does not take a lot of imagination to realize new technologies will become old technologies (think of Research in Motion (TSX: RIM)), or that manufacturing of just about anything can be done cheaper somewhere else.

Does the company have a sustainable competitive advantage? This question cannot be answered simply by looking at numbers in a financial statement. You have to gain some understanding of the company and how it operates, and then you have to compare that to existing and potential future competitors.

Does the company have the financial strength to survive a downturn? Low debts and money in the bank are great indicators for survivability, but you also have to be sure the company will not be burning through savings and racking up debts in the future unless those investments will somehow pay off in the future.

Is there any hint of poor business practices? If there are accounting irregularities or earnings re-statements or questionable management deals, how do you know there are not more skeletons still hiding in the closet?

What is the catalyst for the stock to return to a reasonable value? Whether the stock price is low for a good reason or a not so good reason, there has to be some catalyst to bring it back to fair value. The catalyst could be as simple as future earning not declining as much as analysts thought.

Final word

The next time you come across a stock with a low PE and trading near a 52-week low, don’t assume there is a safety net built into the pricing. No matter how low a stock’s price has gone, it can always go lower. Perform your due diligence to make sure you are buying value, or you may end up buying a company with no future.