Avoid Value Traps with these 3 Catalysts

stock value trapIt’s one thing to find an undervalued stock. It’s another thing to find one that will spring to its true intrinsic value.

Many companies are great values. Many are value traps – companies that are cheap, and will be cheap for some time. So how can you delineate between companies that are poised to move and companies destined to be cheap for a long time to come?

Catalysts – let’s talk about a few.

Three Killer Catalysts

    1. Share RepurchasesShare repurchases happen when companies buy back their own stock to reduce share count. Repurchases help by reducing the amount of common stock floating on the market, and also by increasing headline earnings per share. The best repurchase programs are those that are enacted by companies with a higher than average institutional ownership of the float. How to find opportunity: check out a site like MorningStar, which lists the ownership by various funds and institutional investors as a percentage of all shares outstanding. The more institutions and mutual fund investors (especially index funds), the bigger the pop!
    2. Dividends – In low rate environments like that which we have right now, a dividend is a great way to get on the radar of income investors. Also, some mutual funds do not hold stocks unless they pay a dividend, meaning that a new dividend could attract potentially billions of dollars in new investment interest. How to find opportunity: look into a company’s conference calls – dividends are a hot topic, one which is discussed frequently between equity analysts and corporate management. A new dividend is more beneficial to existing shareholders than an increasing dividend. Secondly, check out the company’s new dividend relative to peers. I like to use Google’s stock screener to sort by industry and then dividend yield to see how a new or future dividend will place the company within its industry.
    3. Debt Reduction – I love companies that have gone through trouble, but are finding their way out. In such cases, I especially like companies that simply had too much debt relative to their future earnings. As companies pay down debt, or silently acquire their own bonds on the open market, the company earns what is essentially a low-risk return on its cash. How to find opportunity: look for companies that are on the line between junk and investment-grade ratings that have either short-term debt issues, or callable debt securities. Such companies can quickly reduce the cost of debt service, improving profits and making them more competitive in their space. You can get an overview of a company’s upcoming debt maturities here.

Avoiding Value Traps

Businesses are valued based on their value to a private owner – someone who controls all the cash flows coming from a business. When the business uses cash flows in a way that appeases shareholders the value of the company increases on a per-share basis. No one wants to buy into a company that is a poor steward of owner earnings.

Believe it or not, much of what is said in conference calls rarely flows to the individual investor. Those who take the time to listen to management discussion of its plans for deploying cash can get a “leg-up” on other investors. This is where reading people is very important – take notice of what is said, but also how it is said.

You’re less likely to find value traps when management uses its finances to work on the company’s finances. Paying down debt is great for low-risk earnings improvement and margin expansion. Share repurchases are excellent for limiting ownership to mostly long term individuals and institutional investors – and shaking out the “weak hands.” Dividends can really drive performance when a company becomes one of the highest-yielding firms in its space – or when it pays a dividend in a sector not ordinarily known for dividends.

What are your thoughts on picking value stocks?

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