How to Tell the Difference Between a Value Stock and a Value Trap

Value Stocks
Value Stocks

A high-growth, rapid innovator like Apple (AAPL) is hardly the sort of stock you'd expect to find in a value investor's portfolio. Nevertheless, value investing guru Bill Nygren runs a mutual fund that owns some Apple shares.

It seems a bit incongruous, until you hear him explain: "We made our first purchase of Apple in a very weak market -- early 2009 -- at about $80 a share ... Today the stock is just under $350 but should have $100 a share on the balance sheet by the end of next year."

'Price Is What You Pay; Value Is What You Get'

When viewed from that perspective, Apple's shares were a legitimate value play in early 2009. Nygren is anticipating having each share control significantly more cold, hard cash than he paid for it, just three years after that purchase. That's an accomplishment worthy of the "value" designation, even if he did it with a stock that doesn't look like the prototypical value investment.

After all, as no less a value investor than Benjamin Graham once told no less of a protege than Warren Buffett: "Price is what you pay; value is what you get." Nygren got shares in a business likely capable of generating and holding on to upward of $100 per share in cash, and he paid around $80 a stub for it. No matter what industry the company is in, that's a good deal.

Since When Did Tech Companies Become Value Plays?

Nygren is not alone as a value investor owning tech companies. These days, technology stocks are very much fair game for value investors, especially if their share prices reflect a market belief that their best days are behind them. Microsoft (MSFT), for instance, sports a AAA debt rating -- the strongest around -- and a forward price-to-earnings ratio below 10.

Even if Microsoft's moats are being assailed by the likes of Google (GOOG) and its Chrome browser and operating system, it has a heck of a war chest to fight back with. And amazingly enough, Google itself is no stranger to the value investors' portfolio these days. With more than $30 billion in net cash and a forward price-to-earnings ratio below 14, it's not exactly trading at "wing and a prayer" dot-com bubble prices.

Growing Pains Are Good for Investors

Stocks are priced based on the market's immediateexpectations for their futures. Quite often, that leads to a significant amount of recency bias -- or the belief that the most recent past will predict a company's long-term future. Based on that line of reasoning, Microsoft's stock will continue to languish in the $20s because that's what it has been doing for the better part of the past decade.

Of course, Microsoft earned $2.10 per diluted share in its 2010 fiscal year, versus $0.85 in 2000. The tremendous earnings growth Microsoft has seen in that time period essentially means Microsoft's business has "grown into" its stock price, with its shares holding relatively steady as its fundamentals got better.

A similar story can be told among many of the tech titans over the past decade, most notably Cisco Systems (CSCO). Cisco's shares are trading around where they were in 2003, despite dramatically improving earnings since then. Like Microsoft, Cisco's business has grown into its share price, and both could be considered reasonably or even value priced today.

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What Counts Most

Whether it's Nygren pouncing on Apple in the $80 range a few years back or today's value investor pouncing on Cisco in the mid-teens, the story is largely the same. When a stock trades for less than a reasonable assessment of the company's future prospects, it is value priced -- no matter what industry it belongs to.

What matters most is the reasonableness of that assessment of the future. After all, the only reason a stock looks cheap is because the market has a bleaker view of that company's future than you do. The biggest difference between a value and a value trap is whether your assessment is right, or the market's is.

Every once in a while, you'll get what Buffett refers to as a "fat pitch." That's a value so obvious that there's really no question that the market has it wrong. Think McDonald's (MCD), back in 2003 when its troubled "made for you" campaign knocked its shares down to the low teens. Did anyone really believe the Golden Arches were destined for failure, as the market was starting to predict? Of course not, and that's what made McDonald's at the time a fat pitch investment.

Those fat pitches don't appear every day, though. Before you buy an apparent value, ask yourself why your view of the company is better than the market's. If you can answer that question satisfactorily, you may very well have a legitimate value. Even if it happens to be a technology company.

At the time of publication, Motley Fool contributor Chuck Saletta owned shares of Microsoft and Cisco. The Motley Fool owns shares of Apple, Microsoft, and Google.

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