Many investors love the concept of value investing. It sounds simple — just buy low and sell high.
After trying it, however, some give up.
They discover that some stocks trading at low values aren’t bargains. Instead, they’re trading at the proper price, given the weakness in their business model.
Sometimes a stock is cheap because it’s headed for bankruptcy, or carries problems that can take years to resolve.
Citigroup, Inc. (NYSE: C) is an example of this.
The company raised its dividend from $0.16 per share to $0.54 as the stock price fell from $75 to $55 in the early 2000s.
Value investors saw the rising dividend and recognized that Citibank, as the company was called at the time, was an institution. It was too big to fail, and that dividend yield was too nice to miss out on.
Well, the stock fell as low as $0.97 two years later. All of these prices are pre-split. Citi did a 1 for 10 reverse split in 2011 to get its stock price back into double digits. Ignoring the split, on a total return basis, Citigroup remains well below its all-time highs reached almost 17 years ago.
This is just one example of the value trap. There were many others from that time. Some of these companies — like Countrywide Credit or Merrill Lynch — stopped trading.
The trap is a stock that appears to offer value, but the value is simply hiding weakness in the company’s financials. Investors buying these stocks get trapped for years in money-losing positions.
Fortunately, we have a way to avoid this problem…
The Key to Avoiding Value Traps
There are few value investors who can dig into the company’s financial statements and uncover problems. They may also understand the company’s business well enough to spot problems before they appear in the financials.
Another solution is to use value as just an input in the investment decision-making process. My colleague Adam O’Dell does this with the Green Zone Power Ratings.
The Power Ratings system provides scores for each stock, and highly rated stocks have been shown to outperform the broad stock market by 3-to-1 over the next year.
The ratings also include sub-ratings based on six factors that have each shown to beat the market in the long run. The system incorporates Value, Quality, Growth, Volatility, Size and Momentum.
By combining these six factors, we can minimize the problems associated with following any one of them. This reduces the chances of stumbling into a value trap, suffering through a momentum crash, or any other issues that come with the individual factor.
You can use Green Zone Power Ratings by entering the company name or ticker in the search bar here to see both its value rating, as well as how it stacks up in the current market:
- “Strong Bullish” and “Bullish” stocks (rated 61 to 100) are expected to beat the broader S&P 500 over the next 12 months.
- “Neutral” stocks (rated 41 to 60) should track the broader market’s ups and downs.
- “High-Risk” and “Bearish” stocks (rated 0 to 40) are expected to underperform.
Just go here to try it out now.
Until next time,
