Yahoo Finance Zacks Investment Ideas feature highlights: AT&T, Verizon, Advanced Micro Devices, Walgreens Boots Alliance and Apple
For Immediate Release
Chicago, IL – June 13, 2024 – Today, Zacks Investment Ideas feature highlights AT&T T, Verizon VZ, Advanced Micro Devices AMD, Walgreens Boots Alliance WBA and Apple AAPL.
Cheaper Isn't Always Better: How to Avoid the Stock Value Trap
The term “value trap” refers to a stock that has a low valuation in terms of classic fundamental metrics such as the price-to-earnings (P/E) ratio, pays a high dividend, yet is a poor investment that underperforms the market and is “dead money.”
To understand value traps, investors should consider the old saying, “You get what you pay for.” Though my mother always taught me to be frugal as a kid, she also emphasized that I should not be cheap. For example, if you buy nice clothing made from better material, you will take care of it, enjoy it more, and it will last longer. The same applies to the stock market because, often, cheaper is not better.
What Are the Signs of a Value Trap?
To understand value traps, I will break down some classic signs and cover some examples to prove my points.
1. “Cheap” Valuation
As I mentioned, value traps are cheap based on traditional metrics, such as price-to-earnings, price-to-sales, or price-to-book ratios. However, investors need to understand that a low valuation is not bearish but it is not necessarily bullish either. Like most investing metrics, context matters.
For example, telecom giant AT&T has a valuation of 7.75, which is roughly a third of the S&P 500 Index’s 24.4 P/E.
Despite the low P/E (which has been lower than the S&P 500 for years), AT&T is down 25%, while the S&P 500 is up 25% over the past five years.
2. Stagnant Earnings Growth
If AT&T is so cheap, then why are shares underperforming? The answer lies in slowing earnings growth. AT&T’s quarterly EPS was as high as $0.90 in 2019 but it has steadily declined to $0.55 last quarter.
3. Industry Out of Favor
A stock’s industry group plays a critical role in its performance. AT&T is not the only stock performing poorly in the communications industry; Verizon has also performed poorly. Investors should seek disruptors and avoid legacy industries. For example, Advanced Micro Devices, a beneficiary of the artificial intelligence (AI) revolution, grew earnings by 159% last quarter. Amateur investors must learn that Institutional investors will pay a premium for growth, especially in bull markets.
4. A High Dividend Yield Is a Trade Off
New, inexperienced investors often get sucked into buying a stock because it has a high dividend. Pharmacy company Walgreens Boots Alliance is a perfect example of why a high dividend does not ensure “safety” or steadiness in a stock. WBA pays a juicy 6% dividend, yet shares are down 46% over the past year!
5. Caretaker Management
Investors must be vigilant regarding new management teams. All else equal, founder-led companies perform well until the founder leaves, and usually stagnate after. That’s because founders have “skin in the game” and are not afraid to take risks. Conversely, when a new CEO takes over an existing and successful company, their mindset tends to shift from growth-oriented to capital preservation-focused (or what I call caretaker management).
Apple is a current example of caretaker management. With Steve Jobs at the helm, the Apple team was expected to innovate, speed up growth, and launch new products. Meanwhile, with Tim Cook as CEO of Apple, innovation has slowed, and capital preservation has become the goal. For instance, instead of trying to break into the EV market, Cook decided to sunset Apple’s EV program. Instead, the company is hoarding cash and buying back AAPL shares in an attempt to prop them up.
GARP: A Happy Medium
The goal of this commentary is not to make investors avoid valuation at all but rather approach it intelligently. One method of doing this is to take a GARP (Growth at a Reasonable Price Approach). In this method, investors seek moderate growth (low double digits), with a reasonable p/e.
Value Trap Caveat: Brutal Bear Markets
Buying value traps in a bull market is a sure-fire way to underperform. However, a bear market environment (which I define as the S&P below the 200-day) is a time when investors seek stability and cash-rich companies like Verizon or AT&T. As a result, investors must understand how to diagnose the market’s health.
Bottom Line
Cheap valuations do not automatically make a stock a “value proposition.” In fact, investors who chase low valuation stocks will often get caught in value traps and underperform the market.
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Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Zacks Investment Research does not engage in investment banking, market making or asset management activities of any securities. These returns are from hypothetical portfolios consisting of stocks with Zacks Rank = 1 that were rebalanced monthly with zero transaction costs. These are not the returns of actual portfolios of stocks. The S&P 500 is an unmanaged index. Visit https://www.zacks.com/performance for information about the performance numbers displayed in this press release.
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