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Value Play vs. Value Trap: How Can Investors Tell the Difference?

Motley Fool Staff, The Motley Fool

In the universe of U.S. stocks, there are many ways to classify individual equities. Dividend payer vs. non-payer. Large cap vs. small cap. Growth vs. value. But the most important one for investors may be this dichotomy: smart buys vs. dangerous ones.

In this segment from MarketFoolery, host Chris Hill and Motley Fool Asset Managment's Bill Barker respond to a listener who has been looking into the large-cap arena, where growth may be harder to come by. He's found some with P/E values that look favorable, but he's wondering: Are they bargains or traps? The duo try to help him broadly view this question.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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This video was recorded on April 9, 2019.

Chris Hill: Question from Deng, who's writing from China. Deng writes, "I've been listening to MarketFoolery since I started investing in stocks in 2014. Lately I've been looking at some large-cap stocks which may not grow that fast." He cites his examples: Kroger, General Motors, and some airline stocks. He goes on to write, "I'm considering their P/E values, which are below 10, making them cheaper than the market average. Are they a bargain? Or are they potential traps?"

Oh, the age-old question, Deng: value play or value trap? That is always the thing that sucks in...I was going to say value investors, but really, a lot of investors. There are growth investors who see a stock get knocked down 20% in one day and immediately start thinking, "It's on sale 20%. Maybe I should be jumping in here."

How do you help people think about solving this question? We're talking about more than one stock here. We're not going to go through all of these. But, what do you look for, once you've made that initial calculation of, "OK, here's a large-cap. It's not going away." Sometimes we're looking at large companies that are paying a dividend, so there's some reason to buy them. Maybe the businesses isn't setting the world on fire, but you've done the math, and you say, "Look, from a P/E standpoint, this is significantly cheaper than the overall market. Why shouldn't I buy a few shares?"

Bill Barker: Yeah, it's a good question. I'm looking at data that right now, in comparison to its forward earnings, GE for instance, is at 5.8 times forward earnings. And boy, that sounds cheap.

Hill: That is cheap.

Barker: Over the last five years, the average is 6.2 times.

Hill: For the market?

Barker: For GE. So, it's maybe 5% cheaper than its five-year average, in comparison to the forward earnings expectations. Why is it so cheap? One, the forward earnings tend to be overly optimistic, not only for GE, but for everybody at this time of the year. You've only got one quarter, not even yet reported. So there is the typical enthusiasm about the year ahead. As the year goes down, and companies report, they say, "Well, we're not going to earn quite as much as we thought we would, or you thought we would."

Additionally, just it's a highly cyclical industry, autos. Auto sales have begun to level in decline. That is the way cycles work. You're looking at pretty good rear view earnings for GE. It's just that highly cyclical stocks don't carry big multiples. When they have good earnings, it seems really cheap. I can go back to 2016 and find that the company was trading at four times earnings. Then, after last year, had a little bit of a decline.

Hill: Is this GE, or General Motors?

Barker: General Motors.

Hill: OK. Wow!

Barker: Have I been saying GE this whole time?

Hill: Yes, you've been saying GE this whole time.

Barker: Well, that's pretty cyclical too... [laughs] No, no! General Motors, GM.

Hill: I was like, "How is GE..."

Barker: Dan, can we just filter all that out? Is there some sort of AI programming that can solve all of my misstatements? [laughs]

Hill: If there was an AI program, believe me, the AI program would be sitting in that chair right now. We'll put a little note in the in the description of the podcast, and hopefully people will read that. That makes a lot more sense to me, that you've been talking about General Motors this whole time.

Barker: It makes sense that I would be misstating things for minutes.

Yeah. Kroger is fairly similar. The major grocers, they're not growing very much. In fact, they're under some increased pressure from Amazon/Whole Foods. So they're not really expected to compound earnings, particularly. People aren't going to be eating more next year than they are this year. You're really looking at sort of population growth as the driver of what they can do, other than acquiring other grocery chains, and that doesn't look like the greatest use of capital at the moment, either.

Kroger is trading at 0.16 times sales. Of course, there's very, very, very low margins for grocers. And that's quite a bit less than the five-year average of 0.26 times. On a valuation basis, I'm a little bit more attracted by that. But I'm not really so attracted at what the next five years look like for Kroger.

Hill: Well, I think it's a great point that -- again, the question is, "I'm looking at these stocks and their P/E relative to the market." I think the point you made at the beginning, before you started confusing GE and GM, was, "Don't just look at that! It's a good point of comparison, but you also want to look at, what is the PE of this stock or relative to what it has been?" Compare the valuation to itself. As you said, in the case of General Motors, yes, it's cheap relative to the market, but relative to what it has been over the last couple of years, it's not like it's trading at some amazing discount to what it has been.

Barker: Yeah, you want to compare it to its own history and to its sector, to its closest competitors. In that case, you normally learn fairly quickly whether there's something company-specific or whether it's a broader application to the industry. Ford right now is trading at seven times earnings. A little bit more expensive, but not meaningfully so.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Bill Barker is an employee of Motley Fool Asset Management, a separate, sister company of The Motley Fool, LLC. The views of Bill Barker and Motley Fool Asset Management are not the views of The Motley Fool, LLC and should not be taken as such. Bill Barker has no position in any of the stocks mentioned. Chris Hill owns shares of AMZN. The Motley Fool owns shares of and recommends AMZN. The Motley Fool has a disclosure policy.