Value Traps to Avoid

When seeking great investments, don’t fall for classic value traps. Here are some traps you’ll want to be able to spot:

The too-high yielder: If you run across a company with a tempting high dividend yield (say, above 7 percent), be careful — it may be that the company has limited growth potential, so managers are returning most of the earnings to shareholders (think regional telecoms). Or the company is in a state of decline with a depressed stock price, and investors expect a dividend cut (newspaper companies, for instance). Or the company is in a tax-advantaged structure that doesn’t allow it to retain much capital (real estate investment trusts, or REITs, fit this bill). A high payout is generally good, but don’t expect too much from steep yields.

The Middleman: Middlemen are frequently price-takers on both ends — they’ve little clout with their suppliers or customers. These businesses, such as oil refiners, drillers and chemical producers, have a bumpy ride, given their weak bargaining power. Picture low margins, high capital needs, overcapacity and profits that swing wildly, usually at the whim of outside forces. They’re not always as attractive as you might think.

The IPO: Companies usually go public (via initial public offerings, or IPOs), issuing shares for the first time on the stock market, for one overarching reason: Their investors want to cash in some chips, and they’ve found just the right time (and price) at which to do so. They think they’ve found a patsy — you. Don’t think they want you to join in their successes. Sure, there are always some blockbuster IPOs — but in general, IPOs often underperform the market over their first few years.

Don’t play with investing fire — think twice before investing in such companies, or just avoid them altogether. Instead, focus on finding great, simple-to-understand businesses at good prices. Learn more about value investing at www.fool. com/investing/index.aspx and in “The Little Book of Value Investing” by Christopher H. Browne (Wiley, $20) or “Getting Started in Value Investing” by Charles Mizrahi (Wiley, $20). 