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One of the easiest traps to fall into when making decisions about buying or selling stocks is to make predictions about how well they will do in the future based on how they did in the past. As a matter of fact, it’s such a common error and such a human tendency that every stock prospectus warns against this behavior specifically: “Past performance is not a guarantee of future results”.

Why is there such a strong tendency to want to look at historical performance? There are at least two good reasons.

First, even though it’s appealing to think that market activity can be predicted using some kind of mathematical formula, the truth is that stock market activity is a result of human behavior. So far, no mathematical formula has been discovered that can accurately predict it.

But humans crave stability and predictability. Looking backward to the past gives us the false hope that the future will unfold in a similar manner. However, wishful thinking is not a good basis for sound business decisions. And successful long-term investing in the stock market requires decisions based on solid business principles, not emotions.

Second, there’s a lot of “selling” going on that is thinly disguised as “useful information”. Since investing in securities has become so popular since the end of the 20th century, a lot of “celebrity analysts” have been created in the media. Stock market pundits have their own television shows, radio shows, Internet blogs and newspaper columns.

Information about investing in the stock market has become mainstream entertainment. And a large part of the entertainment is showing charts, graphs and other kinds of “historical” visual proof of the pundit’s ability to predict the stock market’s performance.

One of the reasons this kind of historical visual proof is so tempting to believe is the human tendency to think that if a stock sold at a high price in the recent past, that price must be its “true value”. There is a tendency to think that if its price has fallen, it’s probably a bargain because it will be only a matter of time before the price increases to its “true value” again.

In reality, the history of the stock market is full of companies whose stocks once traded high, then fell never to rise again. Anyone who owned stock in Montgomery Wards or Krispy Kreme knows that all too well.

The inability of a stock’s past performance to predict its future performance is the reason that many smart investors don’t rely heavily on measurements like the P/E ratio, or other measurements that look to past quarters’ performance. As Warren Buffett has proven time and time again, buying stocks based on the strength of the company’s management is a much better strategy.

By Louis Basenese
Contributing Writer
Money Morning

Consider this your warning…

With thousands of stocks down 50% (or more), investors are salivating over the bargains. But for every true deal, there are at least three “value traps” – stocks destined to languish at depressed levels indefinitely. Or worse, get cheaper still.

Think Kmart Corp. here. In late 2001, it became the poster child for value investors. They argued it was dirt cheap based on countless metrics like book value and sales. And it was destined for a historic turnaround.

Sure enough, the stock went from the bargain bin to the trash heap, as the company filed bankruptcy in early 2002.

So, before you go bargain hunting in this market, arm yourself with this list. It could be your only chance to avoid getting snared by the countless “Kmarts” begging for your investment…

10 Questions You Should Be Asking

In theory, a value stock is a beaten-down company that’s 1) cheap compared to its earnings, its competitors and/or some other relevant benchmark and 2) poised for a turnaround.

In contrast, a value-trap is simply a beaten-down company that’s cheap compared to its earnings, its competitors and/or some other relevant benchmark, but never quite turns it around.

Unfortunately, no formula exists to calculate when, or if, a turnaround will ever occur. But, these 10 questions should help. And ultimately, keep you out of most value traps…

Is there a near-term catalyst?
First things first, if there’s nothing on the horizon – like a new product launch, key marketing arrangement, a shake-up of the executives, the conversion of a massive order backlog, etc. – we shouldn’t bother. Companies and stocks need catalysts in order to advance. If none exist in the next 12 to 18 months, chances are the stock will be stuck in neutral, or worse, reverse.

What are insiders doing?
Nobody knows the company – and its future prospects – better than the insiders. If they’re not salivating over the “cheap” prices and backing up the truck, we shouldn’t either.

Is the company addicted to debt?
Too much debt magnifies the impact of tough times. As sales decrease, interest payments take up more and more of the company’s earnings. Not to mention, unwinding leverage is a time-consuming process. So, even if the company boasts new, fiscally responsible management, beware. Or as Warren Buffett observes, “When a management with a reputation for brilliance takes on a business with a reputation for bad economics, it’s the reputation of the business that remains intact.”

Does the dividend yield seem too good to be true?
Value investors love to tout they “get paid to wait” for a turnaround. Granted, many stocks do maintain their dividends through a downturn. But countless others don’t. They slash or cancel them altogether, just to stay in business. No matter how tempting, tread carefully when the dividend yield hits double-digit levels.

Is the company just as “cheap” based on the future?
At first glance Eastman Kodak Co. (EK) appears dirt cheap, trading at a price-to-earnings (P/E) ratio of 2.96. But don’t be fooled. Or get too easily excited. Remember, the P/E ratios cited on most financial websites are historical. And as investors, we don’t care what a company was worth… we care about what it will be worth. So before you buy, make sure the stocks forward P/E ratio is similarly attractive. (FYI – Eastman’s is not. It trades at 27 times forward earnings. Hardly cheap.)

Which direction is the company’s market share headed?
A general economic slowdown is one thing. But when a company’s losing market share, too, that’s an indication that a competitor has a better mousetrap. And while economic growth is cyclical, market share is not. Even if the economy or industry turns around, chances are the company’s market share won’t.

Does the company operate in a highly cyclical or moribund industry?
If you go hunting in a highly cyclical industry (like semiconductors) you’re asking for trouble. Same goes for industries destined for obsolescence (like print media). To win with these stocks, you need both the company’s misfortunes and the industry’s to reverse course.

How’s the free cash flow?
Earnings can be massaged, manipulated or completely fabricated. But cash cannot. So, make sure free cash flow is stable, or growing. If nothing less, it provides management with a little wiggle room, or margin of error when considering ways to speed up a turnaround.

Is the stock liquid enough?
Just like insiders provide support to share prices, so do institutions (mutual funds, pension plans, hedge funds, etc). Both groups can move stocks prices quickly and significantly. However, many institutions can’t or won’t buy stocks trading for less than $10, with a market cap below $1 billion and/or that don’t trade several million dollars worth of shares each day. Without the potential for institutional ownership, a quick rebound in prices becomes less likely.

Does the company have a sustainable competitive advantage?
For a stock to turnaround we need the company to thrive, not survive. That’s not possible without a sustainable competitive advantage. So stick to companies like Apple Inc. (AAPL) that are light-years ahead of the competition in terms of design, market share, new product offerings and/or technology.

In the end, don’t kid yourself. Detecting a value trap is no easy task. Even the best investors occasionally get snared. Think Bill Miller (with Countrywide and Freddie Mac (FRE)) and Carl Icahn (with Yahoo! Inc. (YHOO) and Advanced Micro Devices Inc. (AMD)).

But at the very least, these 10 questions will ensure you never buy blindly, or on price alone.

[Editor’s Note: For additional insights on value investing, check out Investment Director Keith Fitz-Gerald’s recent special investment research report on the same topic: click here.

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