John Dorfman—Watch Out for ‘Value Traps’ While Seeking Treasures

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By JOHN DORFMAN

Time and again, I’ve championed the idea that investors do better with cheap, unpopular stocks than with expensive and popular ones.

I’ve made that point so often and with so much fervor that some people may have concluded I never met a cheap stock I didn’t like. That’s not quite true.

There is a phrase for stocks that are cheap but deservedly so: “value traps.” Some people prefer the epithet “perma-cheap.”

No doubt I’ve unintentionally recommended some value traps in this column during the past three years, but I hope not many. Two ways I usually try to avoid value traps are to insist on profitability (for example, a return on stockholders’ equity of 15 percent or more) in the stocks I buy, and to insist on a strong balance sheet (not too much debt).

Looking for insider buying is another technique that can help keep you from getting your portfolio’s limbs caught in a value trap. If a stock is undeservedly cheap, often the corporate officers and directors will take a hint and buy.

You can also look for a modicum of earnings growth historical growth, not just projected. If the stock is a turnaround situation, I usually try to wait for some concrete sign that the turnaround has begun. The less demonstrated growth there is, the more confident you need to be in management’s ability to turn things around.

Distinguishing a value trap from a genuine value is always difficult. J.C. Penney Co. Inc., Hercules Inc. and Ryder System Inc. are three very cheap stocks that I fear may be value traps.

J.C. Penney, based in Plano, Texas, earned $838 million in 1996 and hasn’t come close to that figure since. Earnings were $336 million, or $1.69 a share, in the fiscal year ended Jan. 31, the worst showing since 1992. Analysts look for only 56 cents a share for the fiscal year in progress.

For the coming five years, analysts estimate J.C. Penney’s earnings growth rate at 9 percent. This may be a triumph of hope over experience, since in the past five years profit has been declining at the rate of 23 percent.

J.C. Penney owns Eckerd drugstores, which chip in about a third of sales. Eckerd was supposed to be the bright spot in this picture, but it has struggled itself lately. Penney’s plans to create mini-stores within its department stores are unlikely to juice up sales much, in my opinion.

In July, J.C. Penney hired Allen Questrom, 59, from Barneys New York Inc. to be its new chief executive. Questrom had been with Barneys only briefly. He was chief executive of Federated Department Stores from February 1990 through May 1999. Questrom is clearly an experienced retail executive. I’m not convinced he has a vision that will help J.C. Penney turn the corner.

Kmart strength

In late September, I recommended Kmart Corp. Like J.C. Penney, Kmart is a big retailer that has performed poorly in recent years. Yet Kmart has a better balance sheet: Its debt is about 47 percent of equity, compared with about 93 percent at J.C. Penney, and the stock is cheaper. Plus, I think Kmart’s new chief executive, Chuck Conaway, is taking symbolic and concrete steps to shake things up. I owned Hercules Inc. in my personal account from late 1997 to mid-1999 and suffered a substantial loss. I believed at the time that the Wilmington, Del., chemical company was sharpening its focus and would produce fewer chemicals with higher profit margins than in the past.

I no longer believe that. Instead, I believe that Hercules management finds it difficult to resist acquisition opportunities, and lacks a clear strategic focus.

Analysts foresee earnings growth of 10 percent a year over the coming five years, but they had an outlook at least that rosy when I bought the stock about three years ago. Sales have grown at a 2.9 percent annual pace over the past five years, and earnings have fallen at a 9 percent annual clip.

Ryder System, based in Miami, has been in and out of several businesses during the past two decades: aviation services, truck stops and school bus fleet management, to name a few. It also left the business for which it was best known renting trucks to consumers.

Today, Ryder concentrates on leasing trucks to businesses and providing related logistical services. But all the changes haven’t resulted in a much more profitable company. Earnings per share (fully diluted from continuing operations) were $1.76 in 1999, down from $2.03 the prior year and also below the levels of 1995 and 1996.

Ryder’s stock price is tempting indeed at $17.50 as of last week, which is only nine times recent earnings and 0.8 times book value (corporate net worth per share).

It’s the debt level that puts me off.

John Dorfman, president of Dorfman Investments in Boston, is a columnist for Bloomberg News. His firm or its clients may own or trade investments discussed in this column.

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