Watch Out for These Eight Dangerous Investing Pitfalls

The Weekend Edition is pulled from the daily Stansberry Digest.

Today, I want to warn you about one of the biggest mistakes you can make as a value investor...

You see, not every stock that appears undervalued is exactly as it seems. In fact, some stocks that look mouth-wateringly attractive at first could eventually destroy your portfolio.

I'm talking about so-called "value traps."

As a value investor, I'm always on the lookout for cheap stocks – those trading well below my conservative estimate of their "intrinsic value," or what they're actually worth. Such stocks are usually out of favor with investors... Therefore, they're trading at low multiples of their revenue, earnings, free cash flow, book value, or perhaps all of these metrics.

You can make a lot of money in these stocks when the market realizes their true value. However, sometimes a situation isn't as good as it first appears. It can be a trap.

At first blush, value traps look just like any other value stocks...

But it's misleading... You see, unlike genuine value stocks – in which the business turns around (and the stock follows) – these businesses are in a terminal decline.

While such stocks seem cheap on the surface, you'll never make any money with them...

If you buy them cheap enough, you might be lucky and break even. But with most value traps, you can lose a ton of money... As the business declines, the stock follows it down.

I've been caught in more value traps than I care to remember. But my pain can be your gain... I don't want you to fall victim to this phenomenon.

So today, I'll discuss the telltale characteristics of these stocks... and help you learn how to avoid them and dramatically improve your investing results.

A classic example of a value trap is camera and film company Kodak...

Of course, most folks are familiar with Kodak. The company traces its roots all the way back to the 1880s. Kodak mastered the "razor and blades" business model... It would sell inexpensive cameras (the razor) and then make large profits from its film sales (blades).

For decades, Kodak had a bulletproof global franchise. But then, digital cameras came along, putting Kodak's business in peril. The company could no longer continue to profit from selling its film to customers. It was a business in terminal decline.

Still, Kodak checked most of the boxes you'd want in a value investment: a century-old, iconic business... an incredible brand name... a global distribution system... and most important, its stock looked cheap to investors the whole way down. Plus, for a time, the company paid a large dividend.

(That's another dangerous aspect of value traps... Investors often get lured in by an attractive dividend, thinking they'll earn steady income. But as the business keeps deteriorating, investors lose in two ways: holding the stock on the way down and suffering as the company inevitably slashes the dividend.)

Bill Miller at Legg Mason's Value Trust – one of the most famous and successful value investors ever – got sucked into the Kodak trap. Long after the advent of digital cameras, Miller made a massive bet on Kodak around the start of the 21st century.

Miller wasn't a foolish man... Obviously, he could see the shift toward digital cameras. But he believed it would happen slowly, allowing Kodak to continue to earn big profits for many more years. Plus, he thought the company could successfully compete in the new arena.

Of course, that isn't what happened. Consumers rapidly switched to digital photography and stopped buying film. And Kodak failed to compete effectively in the new world.

It eventually filed for Chapter 11 bankruptcy protection in January 2012. Miller stubbornly held his Kodak shares for a decade until 2011, losing more than $550 million.

On the flip side, not all declining businesses are value traps...

In fact, companies stuck in an extended decline often make the smartest, best-performing value investments. The difference is that these companies successfully turn things around.

Take fast-food giant McDonald's (MCD), for example...

Early in my career, from 1999 through 2002, McDonald's fell on hard times. One of the most widely held stocks in America, it had been a growth stock for several decades as Americans gorged themselves on more and more cheeseburgers, fries, and milkshakes.

But then the company went through a terrible period during which it failed to come up with fresh new products, built too many stores (thereby cannibalizing its existing ones), and engaged in an insane price war with one of its chief competitors, Burger King. All this led to 23 consecutive months of declining "same-store sales."

CNBC's Jim Cramer urged the public to avoid McDonald's stock, calling it "unownable." And around that time, people started believing that a growing number of Americans would start eating healthier.

As a result, McDonald's stock declined for more than three years, plunging from around $44 per share in 1999 down to a low of about $12.50 per share in 2003.

But unlike Kodak, McDonald's was able to right the ship...

As it turned out, most Americans didn't abandon McDonald's. Sure, some folks started eating healthier. But most continued to enjoy the company's convenient, inexpensive, tasty food.

To turn things around, the company hired Jim Cantalupo as its new CEO. He was a company lifer. Wall Street hated that... Analysts thought the company needed new blood. But I saw greatness in the old McDonald's – before recent CEOs had started pandering to investors' short-term demands.

And more important, the real estate caught my eye. I realized that the company's land and buildings were worth nearly its entire share price. You were essentially getting the operating business for free.

As a result, McDonald's became one of the best investments I ever made...

I bought the stock at about $16 at the end of 2002. A few months later, after the stock fell another 20%, I added to my position – putting 10% of my entire hedge fund into the stock.

Of course, as you know, McDonald's didn't die. Cantalupo's turnaround plan worked beautifully. Two years later, the stock had doubled. Today, shares trade around $190 – a gain of more than 1,500%.

You may be wondering how to tell the difference between the next Kodak and the next McDonald's...

I've found eight characteristics that can help determine whether a business is permanently impaired (likely making its stock a value trap), or ripe for a turnaround (a classic value investment).

In many cases, the first two characteristics go hand in hand: a company with unsustainable or illegal business practices, and a company under legal or regulatory scrutiny.

The most famous short call of my career – flooring company Lumber Liquidators (LL) – met both of these characteristics, as did infamous drugmaker Valeant Pharmaceuticals.

A few years ago, I learned that Lumber Liquidators was importing and selling laminate flooring made in China that contained dangerous levels of formaldehyde. Even worse, Lumber Liquidators falsely labeled these flooring products as environmentally compliant.

The company's stock peaked at more than $115 per share in November 2013. By August 2015, less than two years later, shares traded for around $12 – a 90% collapse.

Things were even worse for Valeant investors...

The company sucked in more smart value investors and incinerated more capital than I've ever seen. Its business model was based on making endless acquisitions and then jacking drug prices through the roof. Neither of those strategies were technically illegal, but both were unsustainable.

As the government cracked down on prescription drugs, Valeant's stock took a beating. This made it impossible for the company to make more acquisitions.

The stock plunged from more than $260 per share in August 2015 to around $8.50 less than two years later... an incredible 97% loss.

The third trait, businesses made obsolete by technology, has affected more than just Kodak, of course...

It's a seemingly endless list.

The brick-and-mortar retailers getting destroyed by online powerhouse Amazon (AMZN) fit the bill. The same can be said for Netflix's (NFLX) old "DVD by mail" business, Blockbuster Video, print newspapers, businesses that sold pagers, and check-printing companies.

As technology evolves, the victims pile up.

My former student Gabriel Grego exposed an example of the fourth trait last year – accounting fraud...

Grego, who founded Quintessential Capital Management, suspected that global fashion retailer Folli Follie was overstating its sales. So he got to work. He took the list of 630 stores published on the company's website and worked with his team to call or visit nearly all of them. What he discovered was shocking... Folli Follie actually had only 289 stores.

Grego presented his findings to a room full of reporters and hedge-fund managers during one of my conferences. Naturally, the stock collapsed after the news broke. Within two weeks, regulators halted trading of the company's stock. Folli Follie later filed for bankruptcy, costing shareholders more than $1 billion.

Classic examples like the now-bankrupt energy titan Enron and telecom giant WorldCom in the 1990s and 2000s also fall into this category.

I believe electric-car maker Tesla (TSLA) will ultimately suffer from the fifth trait – a wave of new competition...

Tesla deserves credit for almost single-handedly forcing every major carmaker in the world to invest heavily in electric cars. While this is good for humanity, it isn't good for Tesla...

A tidal wave of competition is now hitting showrooms. Many carmakers are now making electric vehicles. I think this explains Tesla's big earnings miss in the first quarter. And as I explained in the April 6 DailyWealth, I believe it's a harbinger of things to come.

Another recent example is 3D-printing companies...

Back in 2013, investors couldn't get enough of the early movers in the space.

But when I went to the Consumer Electronics Show that year, I could see dozens of competitors producing similar products at much lower prices. So I warned investors to stay away from the stocks of the market leaders. Sure enough, they soon plunged 90%.

Another trait that can trick value investors is a one-time event that artificially inflates earnings...

That brings us back to Lumber Liquidators.

One reason the stock had risen so high was a natural disaster. In October 2012, Hurricane Sandy hit the East Coast. It was one of the costliest natural disasters on record, causing some $70 billion in damages.

Of course, rebuilding efforts started almost immediately after the catastrophe ended. People all up and down the East Coast needed new flooring to repair their damaged homes.

Lumber Liquidators, which has a strong presence in the region, benefited tremendously... The post-Sandy boost to the company's business played a big role in the 600% jump in its stock price through late 2012 and into 2013.

But of course, after the initial surge in demand, the year-over-year comparisons were ugly in 2014. As a result, the stock had been cut in half even before a 2015 story on television news program 60 Minutes exposed the company's formaldehyde problem.

The seventh trait relates to companies in cyclical industries that often over-earn at the peak of a cycle...

Cyclical companies often get a big earnings boost as the cycle peaks. But during the ensuing downturn, their earnings plunge.

Ironically, the worst time to buy the stock of a cyclical company is when its price-to-earnings multiple is lowest because that's when earnings are at a peak.

These industries can also suffer from one-time events that artificially inflate earnings...

For example, if a large factory that produced 20% of the world's supply of a specific chemical went offline for some reason, this would cause a supply-demand imbalance. In turn, prices for the chemical would rise and earnings would become inflated... but only temporarily.

And finally, the eighth trait is when fads come to an end...

Think back about 15 years ago. It seemed like everyone was wearing a pair of Crocs (CROX). The rubbery foam shoes entered stores in 2004. Their popularity soared almost instantly... By 2007, the company sold 50 million pairs per year and hit $850 million in annual sales.

In early 2006, Crocs completed its initial public offering. Initially, shares traded around $13 per share. But as the fad gained steam, the stock soared above $70 a share in late 2007.

And then it all came crashing down... Between the financial crisis and the fad coming to an end, CROX shares were decimated, falling to less than $1 only a year later.

The next time you see a stock that looks like a no-brainer, keep these eight traits in mind...

Among the many companies suffering earnings declines, it isn't easy to figure out which ones will turn things around– like McDonald's... and which are destined for oblivion – like Kodak.

But if you can keep these eight lessons in mind, you'll be well on your way to success as a value investor.


Whitney Tilson

Editor's note: Whitney's story is one of the great untold mysteries of the investment world. And it all began with a single, radical strategy. On Wednesday, during a special event, he shared all the details of how he used this strategy to grow his hedge fund from $1 million to $200 million. And for a limited time, you can watch a full replay of the event right here.