Value Stocks vs. Value Traps
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
A contrarian mindset can be very productive when it comes to producing long-term investment returns. Value stocks, those that are avoided by most investors due to surrounding negativity about their business, are usually fertile ground to look for the most attractive bargains with a long-term perspective. But investors need to be careful -- cheap companies sometimes turn out to be value traps instead of value investments, and the consequences can be dire for a portfolio.
A value trap is a stock that is losing its value over time due to enduring factors in its industry, as opposed to transitory hurdles. On some occasions there are evident signs of the business deterioration in the company's financial statements, like in the case of Best Buy (NYSE: BBY), which has moved from profitability to losing money over the last months.
Best Buy is facing tough competition from different sources. Discount retailers like Costco (NASDAQ: COST) have very efficient cost structures, and the commoditization of the electronics business has made price an increasingly more important factor in terms of competitive strength. At the same time, online retailers like Amazon (NASDAQ: AMZN) are capitalizing on their enormous scale and efficient operations to become dominant players in the electronics industry.
The main advantage Best Buy has over companies like Costco and Amazon, which compete mostly on price, is its workforce of knowledgeable employees and its differentiated service. But the company doesn't seem to be working to solidify that strength. Quite on the contrary, Best Buy has embarked in a deep restructuring process that includes store closings and employee layoffs.
In order to save some money and reduce operating costs to recover profit margins, Best Buy may be killing its best asset in the competition against low-price players, and this could be a really expensive decision in the long term. Reducing costs can be a dangerous move when it means eroding the company's competitive position, and investors should be very careful about this possibility when it comes to considering a position in Best Buy.
GameStop (NYSE: GME) is another business that's facing serious challenges from mass merchants and online retailers. At the same time, game developers are moving to direct downloads, a more efficient distribution method, and this could seriously affect GameStop's business. GameStop is very strong in the used video game retail market, and this exposes the company to changing conditions from games and consoles developers.
Developers have increasingly placed nontransferable downloadable content in their games to discourage used trade-ins, and have also invested in software that limits functionality for used buyers by tying each purchase to a non-transferable online account. These companies don't make any money from the used videogames business, and there are rumors about the next Microsoft (NASDAQ: MSFT) consoles precluding used videogames from functioning at any level.
Microsoft has not confirmed these rumors, but this could be a real threat to GameStop. Why would developers allow used videogame trades if they are probably losing sales because of that business, while not making a cent from those transactions?
Social games, the growth of smartphones and tablets and constantly evolving new technologies are true concerns for GameStop. The company is rapidly improving its own digital distribution capabilities, but the paradigm shift toward digital would mean more direct competition from developers, and could also be an important blow for GameStop's used videogames business, which accounts for nearly half of the company's profits.
Companies like Best Buy and GameStop are surrounded by some serious negativity, and that could be a sign of opportunity for contrarian investors. But these businesses need to show their ability to transition through their many challenges efficiently, and there is not much evidence that they can. Investors beware what looks cheap may turn out to be really expensive.
acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com, Best Buy, Costco Wholesale, GameStop, and Microsoft. Motley Fool newsletter services recommend Amazon.com, Costco Wholesale, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.