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Everybody loves a good deal.
Whether it’s buying a groceries, home appliances, or cars, everyone wants to get more bang for their buck.
And it’s no different in the stock market. But unlike comparing prices of chicken at the grocery store, investors look at valuation metrics like the price-to-earnings ratio to determine how good of a “deal” they’re getting on a stock.
But like many things in life, just because something is cheap doesn’t mean it’s a good investment…
…and it’s a common trap many investors fall into.
The Illusion of Cheap
I fell into this “trap” this month.
But it wasn’t in the stock market. See, I just bought my first home in Los Angeles. This included buying new appliances from Lowe’s, which we chose because they were cheaper than Home Depot and other retailers.
On the surface, we got a great deal; 0% interest rate, free installation, and free delivery. Plus, since we bought Memorial Day Weekend, meaning we got 30% off our entire purchase.
But while we got a good deal on the principal, we ended up paying more in other ways. This includes horrible customer service, incorrect items being delivered, and shoddy installations, adding other hidden “costs” to Lowe’s seemingly low price.
So while we paid a lower initial price, it was not “cheaper.”
You may be wondering what buying appliances has to do with stocks.
Well, let me explain it to you…
An Obsession with Discounts
People ask me about buying individual stocks all the time.
And while it’s mostly tech stocks like Tesla (TSLA), Nvidia (NVDA), and Palantir Technologies (PLTR), I’ve had many people inquire about Verizon (VZ)…
…mainly because the stock is percieved to be “cheap.”
And by cheap, I mean it trades at a mid-single digit price-to-earnings ratio and pays a 7.7% dividend yield:
But while Verizon may look cheap on the surface, there are hidden costs that only the trained eye can see.
“Cheap” for a Reason
Verizon isn’t as cheap as it seems.
First, the US telecom industry is highly saturated with intense competition among major players like Verizon, AT&T, and T-Mobile. This means the opportunity for growth in subscribers is limited, putting pressure on Verizon's earnings (and thus its stock price).
Second, Verizon’s is still heavily exposed to landlines and cable TV, both of which have been declining for decades:
Lastly, Verizon’s business is very capital intensive, meaning they spend a ton of cash on maintaining their networks and improving their technology. These costs can be really high and make it harder for the companies to make money and have enough cash to do other things.
These issues are a key reason why Verizon’s stock has long traded as a “cheap” stock…
…while at the same time severely underperformed the S&P 500:
In other words, just because Verizon shares are cheap doesn’t mean it’s been a good investment.
In fact, it’s the textbook definition of a “value trap.”
Don’t Fall Into this Trap
A value trap is an investment that appears to be undervalued based on traditional valuation metrics (e.g., low price-to-earnings ratio or price-to-book ratio). But in reality, the stock is cheap for a reason.
Investors fall into a "trap" by buying seemingly undervalued stocks - like Verizon - only to see the stock get even “cheaper” over time.
But there are a few ways to avoid this trap. First is don’t invest in a stock only because its cheap. Valuation is one piece of your stock analysis and should never be the sole reason for buying a stock.
Next, learn how to analyze businesses. Value traps often have declining earnings, low margins, and high debt levels. And since earnings growth is key to stock market gains, you want to avoid companies with weak earnings like the plague.
Lastly, avoid investing in companies that lack a clear competitive advantage. Look into whether the company has a unique selling proposition or a competitive edge that sets it apart from its competitors.
If you keep track of these three factors, you’ll save yourself a lot of headaches down the line.
Keep Your Losses Small (and the Gains will Follow)
I know it’s tempting to buy stocks - or appliances - because they’re cheap.
But just like with many things in life, you get what you pay for. That doesn’t mean completely ignore valuation when doing your stock research. But instead of focusing squarely on how “cheap” a stock is, make sure to watch how well the business is doing.
This includes the company’s earnings growth, debt levels, and competitive position.
Because while a stock may seem like a good buy because it’s cheap, remember that stock is likely cheap for a reason.
Stay safe out there,
Robert