Investing Tip: Beware of the Value Trap

It was actually an article in The Wall Street Journal a little more than a week ago called "Rule of Thumb Hammered" (subscription required) that got me thinking about this subject. The article talked about the recent performance of some of the homebuilding stocks like KBHome (KBH), Toll Brothers (TOL), and Lennar (LEN). Despite these stocks seeming like a steal on some traditional valuation metrics, they have been performing very poorly.

The WSJ article pointed out the low book value multiples that the homebuilders were sporting a year ago. Book value, also known as shareholders' equity, is all of the company's assets minus its liabilities. It's the amount of money that would supposedly be left over for investors if the company liquidated all of its assets and settled with its creditors.

The thing that investors need to be mindful of with book value, though, is that the number can often only be as accurate as the valuations of the company's assets. In the case of the homebuilders, their balance sheets are loaded with inventory that can easily fluctuate in value with the housing market. Lennar, for instance, as of its May 31 quarter, had $11.5 billion in assets and 67% of those assets, or $7.7 billion, was in housing and land inventory. Even a relatively small change in the valuation of Lennar's inventory would have a decent-sized impact on its book value.

The same issues were in play with a lot of the subprime mortgage lenders like Fremont General (FMT). Though these guys didn't have land inventory to worry about, they all were holding loans on their books that lost value as more subprime borrowers defaulted on their loans.

But the WSJ article really leads into a much broader topic: the value trap. The value trap can be particularly dangerous for new investors, but I wouldn't say that experienced investors are immune to it either.

Ratios and multiples such as the book value multiple -- or the more popular price to earnings (P/E) multiple -- can be really easy ways to quickly judge the price of a stock. In general terms, stocks with higher multiples are more expensive and those with lower multiples are cheaper. Value-oriented investors tend to focus on stocks at the lower end of the P/E or book value range, hoping to find stocks in that group that have been underpriced by the market.

The key to using these multiples, though, is to not stop with just the multiple. Like the homebuilders and subprime lenders, there's often much more to the story than a low P/E or book value multiple. A company with a low P/E is only worth the investment if you can reasonably expect that it will continue to grow or, at the very least, remain stable.

Kongzhong (KONG), a stock that I've written about here a few times, could be put in this category. After some changes in the rules for wireless value added service providers sent the stock into a tailspin, it was suddenly trading at a very attractive trailing P/E multiple. Many investors, including myself, gravitated towards the stock because of its low multiple, historical growth, and attractive cash position.

Unfortunately, the new policies significantly cramped the company and further developments in the industry have also hurt it. Despite the low P/E that it was trading at last year, the stock has continued to tank. Over the past 12 months it has lost almost 40% more of its value. Though it still trades at under 10x its trailing EPS, Wall Street's forward projections are much lower and the stock is at 24x its expected 2008 earnings.

Of course, you'd have to have been a fortune teller to predict the events that led to the continued slide for Kongzhong, but the key is to know what risks are there ahead of time. There are plenty of stocks out there with very low book value or P/E multiples, but many are that way for good reason.

The bottom line? Do your homework all the way through before making an investment. If a stock looks cheap, figure out why it's that cheap. Though there are cases where the market is very wrong, in most cases stocks are knocked down for specific reasons. If it's a risk you can deal with, go for it, but don't hit that "buy" button based solely on a low multiple.