Academic studies have proven that small-cap value stocks outperform all other types of equity investments over the long run. Applying this research to one’s personal investment portfolio, however, raises three caveats:

1. Value is defined by a snapshot ratio such as price-to-earnings or price-to-book value (lower the better);
2. All stocks priced at or below the threshold value ratio (e.g., bottom 20%) are purchased;
3. The portfolio is rebalanced annually, with all stocks that no longer qualify as value being sold and replaced with newly-qualified stocks.

There are thousands of small-cap stocks and even isolating only the bottom 20% of small-cap names with the lowest price-to-book ratio results in several hundred stocks, far too many for the average investor’s portfolio.

Furthermore, many “cheap” stocks are cheap for a reason — their business prospects are in decline and getting worse. Other small-cap stocks are cheap because of investor neglect despite the fact that their financial fundamentals are solid and improving.

The key to beating the market using small-cap value stocks in a practical manner requires some method for separating the simply ignored winners from the deteriorating losers. 

Don’t Blindly Buy “Cheap” Stocks

By screening for small-cap value stocks with improving financial fundamentals, you can avoid small-cap value stocks that face continued financial deterioration and price declines and isolate those small-cap stocks that have begun a turnaround and promise significant price gains.

Although not a panacea for picking the best small-cap stocks, this method goes a long way towards differentiating those “cheap” stocks that are promising investments from those that are value traps.

“Cheapness” by itself is no way to find good investments. One should never chase the highest yielders, but focus on solid businesses that have the ability to sustain and grow dividends over time. Similarly in value investing, one should not chase the cheapest stocks but instead focus on those stocks showing the largest discrepancies between intrinsic value — based on discounted future free cash flows —and current market value.

Value is a relative thing, not an absolute measure. A stock with a price-to-earnings (P/E) ratio of 20 can be a better value than a stock trading at a 5 P/E ratio if the growth rate of the more “expensive” stock is high enough. The P/E ratio in isolation is meaningless because it only measures value in a snapshot of time without regard to future wealth generation potential. As I have previously written:

“If a dollar is a dollar is a dollar, why wouldn’t all companies have the same P/E ratio? When you buy a stock, you’re not just buying the earnings the company makes this year, but also the earnings it’s expected to make next year and the year after that.

What if the earnings expectations for next year are $20 for Company A but only $10 for Company B? Wouldn’t you be willing to pay more for a dollar of Company A’s earnings this year if you expected to get much more in the following year? Of course you would.

This is why P/E ratios are much higher for companies with high expected earnings growth rates than for companies with lower expectations. So before buying a stock, you need to look not only at its P/E ratio, but at its expected earnings growth rate as well.”

Those companies with improving fundamentals are more likely to generate larger cash flows in the future, whereas those with weak fundamentals are more likely to remain stagnant or suffer deteriorating future cash flows.

Two Forms of Uncertainty

Value traps come in two forms of uncertainty: current asset and future cash flow.

A stock’s value has two components:

(1) existing value based on current net assets (i.e., shareholder equity or book value);

and

(2) future value based on future discounted cash flows. 

For most companies, future cash flows are a much larger component of total value than existing net asset value, but for resource-heavy industry sectors such as mining, energy production, and finance, existing value is more important and, consequently, a snapshot value measure such as price-to-book-value can provide a good indication whether a stock is undervalued or not.

However, just as future cash flows are uncertain, so too can current value measures like book value. Examples include estimating how many barrels of oil an oil company actually possesses underground or estimating the credit-worthiness of a bank’s borrowers and what percentage of the bank’s loan assets will actually be paid back.

The 2008 financial crisis provided several examples of companies thought to be “cheap” based on book values exceeding their market capitalizations.

Richard Pzena, a well-respected hedge fund manager and former director of equity research at Sanford C. Bernstein & Co., told the Value Investing Congress in November 2007 that home-mortgage securitizer Freddie Mac (Other OTC: FMCC) was “the cheapest stock he’d ever seen” and he followed up with a letter to Barron’s Magazine in March 2008 stating that both Freddie Mac and Fannie Mae (Other OTC: FNMA) were “extremely undervalued.” As it turned out, both stocks were extremely overvalued and lost 99% of their value by the end of 2008.

Similarly, between 2005 and 2008 hedge-fund manager Mark Sellers slowly put almost all of his investors’ money into natural-gas driller Contango Oil & Gas (NYSE: MCF), only to watch the stock lose 80% percent of its value by October 2008 as the price of natural gas plunged far below the $7 per Mcf level that Sellers thought was the long-term bottom.

Investors in his fund redeemed their money en masse, and Sellers was forced to shut down his fund. To this day, 4.5 years later, Contango’s stock remains more than 30% below its peak price in the $70’s that was reached in Seller’s purchase period during 2006 and 2007.

Freddie Mac and Contango Oil were both value traps that ensnared very smart investors who miscalculated the real value of their financial and natural gas assets, respectively, and interpreted their current stock prices as “undervalued.”

This overestimation of asset values is why Benjamin Graham, the father of value investing, coined the phrase “margin of safety” and required a stock to be trading at no more than two-thirds of estimated net current asset value before he would purchase it (i.e., a 33% margin of safety).

Similar value traps exist in non-asset-heavy businesses that rely on growth in future cash flows for the majority of their value. In these cases, the “trap” is viewing the company’s current PE ratio as undervalued in relation to an overestimated ability of the company to grow earnings in the future. As stated above, for non-resource companies stock valuation and future earnings growth are inextricably entwined. To characterize value investing as having nothing to do with growth estimates is absurd.

Growth vs Value: Buffett’s View

Warren Buffett is one of the strongest proponents of a value-investing definition based on “growth at a reasonable price” rather than Graham’s “current net asset value at a 33% discounted price.”

Buffett explained his value philosophy in Berkshire Hathaway’s (NYSE: BRK-A) (NYSE: BRK-B) 1992 shareholder letter:

“We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.

But how, you will ask, does one decide what’s ‘attractive’? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth.’  Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago).  In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? 

Whether appropriate or not, the term ‘value investing’ is widely used.  Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield.

Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.

Correspondingly, opposite characteristics — a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield — are in no way inconsistent with a ‘value’ purchase. A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future ‘coupons.’

Furthermore, the quality of management affects the bond coupon only rarely — chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity ‘coupons.’

Though the mathematical calculations required to evaluate equities are not difficult, an analyst — even one who is experienced and intelligent — can easily go wrong in estimating future ‘coupons.’  At Berkshire, we attempt to deal with this problem in two ways.

First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows.

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase — irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.”

A company’s value is determined by discounted future cash flows — regardless of whether those cash flows are destined to grow or shrink. Consequently, even a dying business estimated to experience negative growth over the next decade can be “undervalued” if the current market price falls below these shrinking future discounted cash flows.

In his 1989 shareholder letter, Buffett called such companies “cigar butts” that give investors one last puff of pleasure on their way to expiring, but he doesn’t recommend focusing on such companies because it is very difficult to estimate an accurate rate of business decline.

If you underestimate the rate of decline, your intrinsic value estimate will turn out to be too high and you’ll lose money on the investment. It’s better to focus on “wonderful” businesses with quality management because they are more likely to offer up positive surprises, whereas cigar butts are more likely to suffer negative surprises.

Avoiding Value Traps: The Key to Success

Performing a full-fledge discounted cash flow (DCF) analysis is not only time consuming, but requires an endless number of input assumptions that are likely to turn out to be wrong.

Consequently, the key to successful value investing often revolves around avoiding big losses from value traps rather than finding the few severely undervalued hidden gems. As Buffett said in his 1992 shareholder letter:

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes.

Avoiding big investing mistakes does not require a DCF analysis — rather, it requires a few qualitative “rules of thumb” to identify value traps. Value traps are nothing more than companies whose businesses exhibit a high degree of uncertainty in asset values or future cash flows. Avoiding businesses with high uncertainty will largely eliminate the risk that you will overestimate a stock’s intrinsic value and overpay.

Short-seller Jim Chanos of Kynikos Associates has made presentations at Value Investing Congresses where he presents his criteria and candidates for value traps:

1. Booms that go bust
   
2. Secular industry declines caused by global competition
   
3. Heavy government regulation or outright prohibition reduces competition but doesn’t equal value
4. Technological obsolescence
5. Logistical obsolescence
6. Declining profit margins caused by increasing competition, including patent expirations.
7. Growth by acquisition and merger accounting that allows capitalizing expenses.
8. High debt load.
9. Bad management (i.e., value destroyers)

Looking at all these value-trap criteria, the bottom line is that large-cap “cheap’ stocks are often cheap for a reason and aren’t really values at all. Only small-cap “cheap” stocks — because of investor neglect — have a good chance of being undervalued opportunities.

To quote again from Warren Buffett’s 1989 shareholder letter, don’t be hypnotized by “bargain-purchase folly:”

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Good jockeys will do well on good horses, but not on broken-down nags. When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them.

To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers. The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult.”

Avoiding Uncertainty Is Worth a Higher Price

Even for wonderful companies, value still plays a role as Buffett only buys them if they are trading at a “fair” price.

The key point is that really cheap prices are usually associated with troubled businesses and the difficulty in turning around such businesses is not worth the super-cheap price. The best way to avoid value traps is to seek out what Buffett calls “inevitables” — companies with insurmountable competitive advantages that make it inconceivable that their business will not thrive in the future.

In fact, there are solid investments that make money, even when the overall markets tank.

Over the past three months, my colleague Linda McDonough has deployed a consistently profitable investment strategy through her premium trading service, Profit Catalyst Alert. This money-making system has generated total gains of 592% for her followers. That’s enough to turn $5,000 into $34,600.

Want to know how Linda does it? Click here for a free presentation.