Avoid The Value Trap To Achieve Higher Returns

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Includes: BAC, CHD, D, HSY, SAM, SAN, SD, SDRL, SPY, TR, UNP, WFC
by: Michael Hooper

Summary

Be wary of value traps in banks, oil and consumer stocks.

My sweet attraction to Tootsie Roll goes sour.

I paid a premium for my top stocks.

Value investors spend their lives in the trenches buying stocks at deep discounts to their peers. They believe their bottom feeding will produce top returns. But sometimes these discounted stocks are a "Value Trap" that never go anywhere.

Investopedia says, "The trap springs when investors buy into the company at low prices and the stock never improves. Trading that occurs at low multiples of earnings, cash flow or book value for long periods of time might indicate that the company or the entire sector is in trouble, and that stock prices may not move higher."

There are value traps in all sectors, but I believe traps are common in Oil, Banking and Consumer stocks. I will explore value traps in all three sectors.

Candy stocks

In the 1990s and 2000s, I had success investing in the William Wrigley Co., achieving 15% annual returns until the stock was sold to Mars at 32 times expected earnings in 2008. I was sad to see that stock leave my portfolio.

I looked for other candy companies to purchase. I invested some money in Tootsie Roll (NYSE: TR). Tootsie Roll has a great story and popular products that are part of American confectionery history, its most well known ad campaign in the 1970s was "How many licks does it take to get to the center of a Tootsie Pop?" The company has solid fundamentals, minimal debt, good cash flow and popular brands. TR trades at a P/E of 29, similar to Hershey (NYSE:HSY). In the mid 2000s, I bought a few shares of TR at $24 per share, but the stock never went anywhere. I figured some day the Gordon family that owns the majority of stock in Tootsie Roll would eventually sell out and relinquish control. Ellen and Melvin Gordon have run Tootsie Roll for decades and have no plans to step down. After holding my Tootsie Roll stock for a year, I sold the shares for about the same price that I had paid for them. The stock moved to $29.80 per share recently. There is more value in Tootsie Roll, but how long can investors wait for that to be realized?

I started buying Hershey stock at around $65 per share. Hershey was up 193% over the past five years compared with 25% for Tootsie Roll. I'm glad I put my money with Hershey.

Energy

Investors who chased the energy sector seeking deep-discount stocks with fat dividend yields have taken some hits lately. The energy play has produced big-time losses due to the -50% drop in oil prices. Stocks like Sandridge Energy (NYSE:SD) are hurting. Low oil prices will cut demand for Sandridge's oil and gas exploration business. SD was down -67% over the past three months.

I see many investors looking for an opportunity in Seadrill (NYSE:SDRL). Seadrill is trading at forward 3.68 P/E and trailing 1.22 P/E. The stock is trading at half of its stated book value. It looks cheap. But a closer look and you see earnings growth is not there. In fact, YOY quarterly earnings growth is a negative -47%. I question SDRL's $20.93 book value. With oil prices cut in half, the company's assets are probably worth substantially less at this time. SDRL cut its dividend to save cash. SDRL will lose business in 2015. Who wants to pay for its expensive ocean drilling systems if cheap oil is plentiful on land?

Banking

I know bankers who really got hammered with the stock market crash in 2008-09. Bank of America (NYSE:BAC) used to trade over $40 per share in the mid 2000s, but fell to $3.00 per share in 2009. The stock recently hit $16.90 per share, but has never fully recovered its pre-recession share price. Meanwhile if you had owned the S&P500 or (NYSEARCA:SPY) before, during and after the Great Recession, you would have recovered your principle by 2012 and made phenomenal returns of 32% in 2013 and 13.5% in 2014. BAC is trading at 81% of book value.

Citi is trading at around 80% of tangible book value. This may be a classic value trap.

Banco Santander S.A. (NYSE:SAN) is trading around 86% of book value compared with Wells Fargo (NYSE:WFC) trading at 1.67 times book value. SAN has decided to raise more capital through issuing stock. This will dilute shareholder value.

Banks are over-regulated, pay high expenses on legal issues and deal with a low-interest rate environment that makes it difficult to earn money. Regulators want banks to maintain high capital levels. With interest rates so low, banks can't pay much on savings accounts. Every time you turn around, a lawmaker wants to propose new, tougher standards for banks. Banks already spend a lot of money on internal controls, legal and compliance. Don't buy bank stocks with the idea interest rates are going up because we may see low interest rates for many more years. The 10-year Treasury actually fell from 3.00% to 2.00% in 2014. U.S. bond yields remain low due to worldwide pressures keeping rates down. The Federal Reserve is in no hurry to raise rates, although it hinted we might see an uptick in rates by summer 2015.

If I had waited for deep-discount prices on my favorite stocks, I might not have bought them except in 2009 when all financial assets deflated. I paid a premium for my favorite stocks and bought them on the dips. Now these stocks represent the most consistent and profitable returns in my portfolio. These quality stocks are Berkshire Hathaway (BRK.B, BRK.A), Union Pacific (NYSE:UNP), Hershey, Church & Dwight (NYSE:CHD), Boston Beer (NYSE:SAM) and Dominion Resources (NYSE:D). I bought these stocks using a multiple-buy-on-the-dips approach that reduced risk and increased my returns.

A stock's value is really dependent on a stock's future earnings potential. Positive, upside surprises on earnings usually drive stocks higher. If a company produces higher levels of earnings year after year without diluting shares, the stock eventually will move up in price. But if the prospects for earnings growth is taken away, the stock may never appreciate.

Conclusion

Buy companies that generate large amounts of cash daily, have minimal or no debt and that don't get in trouble with the government. Watch out for the value trap. I'm staying away from oil and banking stocks to devote more capital to my winners. Don't chase losers into the hole of no return. Money not lost is money ahead.

Disclosure: The author is long BRK.B, HSY, UNP, D, CHD, SAM.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.