February Idea of the Month: A Value Trap That Can Grow

By Travis Johnson, Stock Gumshoe, February 19, 2010

Investors always worry about the so-called “value trap,” a company that looks cheap but will forever remain cheap, luring investors in with a low PE ratio and miring them in the muck for years as they wait for others to see the “value” — sometimes we’ll also see “dividend traps,” where stocks entice investors with unsustainable dividends, like PDL Biopharma (a stock I owned years ago, when it was known as Protein Design Labs, but which is essentially running out the string on royalty income for soon-to-expire patents as it yields, for now, 14%).

Today, the stock I want to look into for you might be considered a bit of a “trap,” too — sort of a combination growth/value trap. It looks at first like a rock-bottom value stock, with a trailing PE of about 8 … but when you dig into it further, you see that it’s got remarkable earnings growth of almost 400%. In reality, it’s a very small growth stock with a big lump of one-time earnings from one government contract and, I think, some unappreciated opportunity for significant growth even after the big one-time earnings from this contract run through their books.  So we’re looking at a cash-strong company with earnings that have increased dramatically in recent quarters … but which is also going to see earnings probably fall something like 75% later this year before they resume growth again.

I also want to let you know that, although this isn’t the official focus of my article today, I think more conservative investors have a decent opportunity still to get into the newly-split Berkshire Hathaway, though it’s not as cheap as when I mentioned it last month before the split — analysts really underestimated how much pent up demand there was for an affordable way to buy into Warren Buffett’s money machine. And I am also very close again to being tempted by Hatteras Financial (HTS) and Annaly (NLY), both of which look like they are well positioned to manage through the eventual rising rate environment, but which are also getting hit because of fears (overblown fears, I think) of a rapidly flattening yield curve.  My preference would be Hatteras right now, and I came close to focusing on Hatteras for this note today, but another idea won the battle in my noggin.  Hatteras yields almost 19% again (taxed as income, not dividends, so ...

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