How To Tell If It’s A Value Stock – Or A Trap

After the huge rally growth stocks have had this year, it’s fair to say they’re looking a bit toppy. So it’s only natural that you might be eying the less-pricey end of the market right now. But be careful: it’s easy to get seduced by a cheap stock and to mistake it for good value. In fact, you might want to check out some how-to guides on value investing. Or, better still – since you probably don’t have time to wade through pages of jargon-filled text – you could follow my three simple rules of value investing.

Rule 1: Stay away from cheap commodity cyclicals.

If there’s one thing investors like more than superhigh growth rates, it’s predictability. As a rule of thumb, the more predictable a business is (provided it’s also growing and not declining) the more highly valued it is. On the flip side, the more unpredictable a business is (with massive and erratic swings in sales and profit), the more likely it is to be crowded with dirt-cheap stocks. But remember: dirt-cheap doesn’t necessarily mean good value. Take the oil industry. This chart shows the price of oil, per barrel, going back to the 1950s.

The price of a barrel of the benchmark Brent crude oil. Source: Macrotrends.

Now, the first thing to note is that the price of oil goes up, it comes down, and it goes up again, but there’s little in the way of a trend one way or the other. What’s more, the swings are pretty wild. That makes predicting the price of oil basically impossible. If you don’t believe me, just think back to all the $200 oil predictions late last year when oil was on the up.

Anyway, an oil firm’s fortunes are closely tied to the price of the stuff, which makes the sales and profit of those companies as unpredictable as the commodity itself. And that unpredictability puts a stranglehold on the valuation of their stocks.

I’m not saying that oil stocks are never good investments, but, I have to admit, for long-term investors, I think there are way better places to put your money. See, those cheap prices tend to coincide with a high oil price, which boosts profit (or earnings) for oil firms, lowering the P/E ratio. But low oil prices follow high ones more often than not, and oil stocks tend not to do too well when the price of oil starts to fall.

The message, then, is to be suspicious of cheap-looking commodity-like cyclical stocks.

Rule 2: Seek good cyclicals that are priced as bad ones.

Now, not all cyclicals are equal. There are plenty of cyclical industries that experience ups and downs, but over time enjoy higher peaks and shallower troughs. Sometimes, though, the market can lose sight of that long-term growth potential, and mistake these industries for pure commodity-like cyclicals. And that’s where opportunities lie.

Semiconductors are a great example. This next chart shows global semiconductor revenues since 2016 and forecasts out to 2027. It’s a cyclical industry, with demand for semiconductors flowing alongside the economy’s ups and downs. But over time, tech trends have led to the increase in semiconductor demand – with each peak in global revenue higher than the last. And that looks set to continue.

Global semiconductor revenue. Source: Statista.

Now, with AI fresh on the scene, there aren’t too many cheap semiconductor stocks around at the moment. But, if a nasty recession hits, and stock markets take a tumble, then some of these companies could get tossed into the “just-another-cyclical-stock” bargain bin. It’s happened in tech before: semiconductor leader Texas Instruments was changing hands for less than 16x P/E late last year, for example.

So, keep an eye peeled for the most cyclical parts of the industry, like semiconductor manufacturing equipment firms.

Semiconductors are just one example. There are a lot of other cyclical industries with high-quality, long-term growth companies. From time to time, these firms get tarred with the same commodity-cyclical brush and end up in the bargain basement. And those are the cheap stocks that should get long-term investors salivating. Before you buy, though, be sure to go back and look for evidence that those cyclical peaks in sales and profit are higher than previous peaks. That’s the best indication that a firm is growing over time.

Rule 3: Avoid declining industries.

This is a rather simple one. A declining industry is one where overall sales volumes are falling. Stocks of firms in these sectors rarely make for good investments. But the reasons are a little nuanced. In theory, if the shares of a firm that’s seeing sales volume declines are pricing in rapid declines, but you think the declines will end up being less severe, that should be a good investment. But experience has taught me that it usually doesn’t work out that way. I’ll share two prime examples here, but if you can think of any declining industries that have been good stock investments, please give me a shout.

First example: the tobacco industry. It started to see volume declines around the middle of the last decade. Until then, tobacco volumes were still growing and the share prices were doing OK. Since the industry entered decline, though, it’s been a different story.

Five-year share price performance of leading US tobacco firm Altria (ticker: MO) and the S&P 500 index (SPX). Source: Koyfin.

Second example: cable. Streaming services like Netflix got TV watchers questioning their cable bills some time ago, but the cord-cutting trend moved up a notch around 2016. And soon, cable distribution giants like Comcast and channel owners like Discovery (now Warner Bros Discovery) started to struggle. And then there’s Disney. To say Disney’s in decline is overdoing it, but it has serious problems with its core media operation, and it shows in its stock price.

And if you ask me, I’d say the oil industry could soon be a third example. But that’s another story.

So what’s the big takeaway?

If you've come upon a stock that seems like good value – and it’s not a cheap commodity, nor is it in a declining industry – there’s a good chance that it’s the real McCoy: a genuine value stock. It could be a mispriced cyclical or a once-mighty firm that’s fallen on hard times.

Alternatively, it could be a bad house in a good neighborhood – a firm that theoretically has everything going for it, like a growing industry and an exciting trend, but that just gets out-competed by better rivals. These can be decent investments, even if there are better lookalikes. Intel and Oracle investors have done pretty well over a long time horizon – just not as well as investors in Microsoft or Nvidia.

This is not a 100% fail-safe guide by any means, but the three rules should give you a decent shot at knowing what’s a value stock and what’s a trap.