Don't Get Caught in a Value Trap

In your column a few weeks ago about Benjamin Graham's Stock-Picking Strategies, you warned about cheap stocks you labeled "value traps." What are value traps, and how do investors avoid them?

Easier said than done. Value traps -- cheap stocks that turn out to be stinkers -- are like mirages: You think you've found a bargain-priced oasis only to end up eating sand. "It's a real pitfall for value managers," says Peter Morris, manager of Homestead Value fund, which invests in beaten-down companies. "There's no formula to help you steer clear of value traps."

Often stocks that trade at low price-earnings ratios or similar measures of value are cheap for good reason. Investors need to figure out whether the malaise affecting a company is a temporary setback or the start of a death spiral.

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In the late 1990s, Morris thought shares of Oneida, a maker of china and flatware, were a steal because of the company's low stock price and popular brand name. But global competition and a bloated infrastructure wrecked Oneida's finances, and the company filed for bankruptcy in 2006. Warnings signs of a value trap "don't appear all at once," says Morris. "It's a slow, deteriorating process."

Stick with companies that have a sustainable product or service, Morris advises -- ideally, those whose true value has been misjudged by investors. And you want to avoid companies in moribund industries or those with declining market share. Also, a business with little or no debt that generates plenty of cash is less likely to be a value trap than one with a weak balance sheet.