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Summary Investors that heavily rely on stock screeners for new investment ideas should be cognizant of screener limitations. This article will provide some common examples of low P/E stocks that may be included in your stock screener output. Warren Buffett famously stated that he is “85% [Ben] Graham and 15% [Phil] Fisher”. Retail investors should not ignore qualitative analysis when considering investment ideas. The internet has drastically reduced the information asymmetry between institutional investors and your average retail investor. The internet has introduced investors to discount brokers — do you remember the E*Trade Financial (NASDAQ: ETFC ) ” Wasted 2 Million Bucks ” ad? — and stock screeners. They can be credited for reducing the frictional costs of trading by reducing trading commissions and both the costs and time associated with equity research. Score a big win for the Average Joe investor! However, stock screeners have limitations that can be easily forgotten as you grow more accustomed to using them. Nearly all free and most paid stock screeners are limited to numerical filtering and sorting, with a minimal amount of qualitative analytical functionality. As long as investors are consistently aware of these limitations, stock screeners can be an extremely valuable research tool. This article will provide examples of situations that may cause a stock to appear in your screener output, and how to determine if it is truly undervalued or a likely value-trap. Large Expected Decline in Earnings or Major Ongoing Litigation These stocks tend to be well-known companies that look “cheap” on both an absolute and relative basis. Without digging deeper, it would appear as if Mr. Market has temporarily lost his mind and provided you an outstanding investment opportunity. As Lee Corso would say, ” Not so fast, my friend! ” Investors need to do some scuttlebutt and read the company’s annual reports to confirm why a company is selling at low valuations. Below are some common situations that may cause a stock to appear cheap on a stock screener (some of these situations can provide outstanding returns for investors, if correctly handicapped): Loss of a large contract or customer Major litigation or recall of their product(s) Accounting scandals/Restatement of financials Retirement or Death of an important employee (such as the founder and/or the CEO) Large one-time loss [without impairing the core business] The following are some examples of each situation: Loss of a major contract: For the past two decades, NeuStar (NYSE: NSR ) has been the administrator of the telephone-number portability contract handed out by the Federal Communications Commission. The contract, which allows consumers to take their telephone number to other service providers, gave NSR a rolling 5-year monopoly on telephone portability. This SA article attempts to decipher the effect of the contract lose on NSR’s financials, which accounted for 50% of NSR’s total revenue and roughly 75% of their gross profit. While NSR currently trades at a TTM P/E of 8.3x, it is unlikely NSR will be profitable in the future with their current businesses. An investor purchasing based on a stock screener’s output may be shocked in 12 months to learn that earnings have all but disappeared. Major litigation: The most commonly cited example of major litigation is the “mother of all lawsuits”, the Tobacco Master Settlement Agreement of 1998, which held Phillip Morris (NYSE: PM ) (which has since spun-off Altria (NYSE: MO ), which is better known as Phillip Morris USA – maker of Marlboro cigarettes), R.J. Reynolds (NYSE: RAI ), Brown & Williamson (NYSEMKT: BTI ), and Lorillard (now part of R. J. Reynolds) responsible for at least $206 billion dollars , to be paid over 25 years! Although many of these stocks have performed well over the decades, investors have certainly earned much lower returns on capital than the historical returns (from the perspective of an investor in 1998). A more relevant example is the recent Volkswagen ( OTCQX:VLKAY ) emissions scandal that surfaced roughly a month ago. The consequences are still not fully known at this time, but VLKAY has been found to have falsified US pollution tests of at least 500,000 diesel engines with software that made the cars appear to be cleaner during testing than during actual road operation (the software hid pollution nearly 40x greater than allowable levels [for nitrogen oxides]). VLKAY currently trades at a TTM P/E of 5.75x (-43.4%, including dividends, since 4/1/15), lower than American car companies even though VLKAY was previously thought to be of higher-quality and having a stronger growth profile than its peers. Investors who think VLKAY is selling at bargain prices should be aware of the potential costs ( estimates of > $18b ) of both direct fines and repairs as well as potentially lower sales due to brand damage. This type of situation is so tempting because it can also be the source for outstanding long-term returns. Although there are many examples of accounting scandals at public companies (certainly many more than there should be), there is one example that continues to stand out to this day, Enron . The name “Enron” is synonymous with corporate greed and the realization of their accounting fraud also caused the dissolution of the major accounting firm Arthur Anderson , due to their own role. One of the only positive consequences of the scandal was the introduction of the Sarbanes-Oxley Act , which drastically improved the accounting and auditing of corporations. This well-intentioned law introduced new white-collar criminal offenses and increases associated criminal penalties and improved overall corporate responsibility. It is one of many changes that have generally made the equity markets safer for retail investors. It is often extremely difficult to handicap the odds of recovery for companies in the middle of an accounting scandal. There are numerous other examples of accounting scandals that leave equity holders with nothing. Investors are usually better off to avoid this type of situation altogether and this is one of the worst reasons a stock may appear to be cheap on a stock screener. Retirement/Death of a key employee: Perhaps no leader in the 21st century (and much of the 20th century) was more important to their company than Steve Jobs was to Apple (NASDAQ: AAPL ). Known for his turtlenecks and highly anticipated (and never disappointing) news conferences, Steve Jobs resigned from his position as chairman and CEO on August 24th, 2011 (he would sadly pass away less than two months later on October 5th, 2011). Stock screeners are unable to capture the importance of leaders and AAPL’s fortunes always seemed tied to whether Jobs was on the payroll or not. At the day of his retirement AAPL’s stock fell -5.5% even though numerous sell-side investment analysts came out in support of AAPL’s future prospects. This SA article does an excellent job of capturing the investment community’s opinions at the time. This is one of the rare reasons a stock may be relatively cheap and it may still be a strong investment opportunity. Rarely can one person so drastically improve the value of a company like Steve Jobs did over his lifetime for Apple, yet nearly everyone believed [correctly, in hindsight] that APPL would be just fine without him. Investors who purchased AAPL on the day of Jobs’ retirement have earned more than 20% compounded returns, excluding the dividend. In general, outgoing CEOs can provide an excellent opportunity for investment and this is one of the few things stock screeners can pick up. Large one-time loss [without impairing the core business]: These are generally the most profitable situations, but can also be the most difficult to recognize at the time. Stock screeners will generally catch these stocks if you search for low P/E and high ROE or ROIC. However, there are two important assumptions that must both be true for this situation to lead to high expected returns going forward. 1) This must truly be a one-time loss and 2) the core operating business must be unaffected by whatever caused the loss. Again, both of these must be true to provide an excellent investment opportunity. This situation can look a lot like situations #1 and #2 since they all involve a large one-time loss. However, situation #1 obviously impairs the core business by definition since the large customer or contract often represents a substantial portion of the company’s overall revenue and profitability. Situation #2 may overlap with this situation, at times, but again the key difference is whether the core business was impaired or not. The current case of VLKAY provides an excellent on-going case study since analysts are currently trying to determine how much the company will ultimately owe in fines, how much in additional fines will VLKAY be liable for (due to the property damage caused to VW car owners through lowered resale value), and over what time period these damages will need to be paid. An investor can estimate the answer to each of these questions and try to model VLKAY’s liquidity situation to estimate whether they will survive or not. British Petroleum (NYSE: BP ) went through a similar situation with the Horizon oil spill . After a temporary bounce in the stock price, BP has since underperformed its large-cap oil peers as they were forced to sell off many assets, which impaired their core business. We can find examples of successful investments within this situation by looking at Berkshire Hathaway’s (NYSE: BRK.B ) stock portfolio. Warren Buffett first invested in American Express (NYSE: AXP ) in Jan-1964 after the stock had fallen -43%. The stock fell because it was discovered that AXP had provided loans against the watered-down vegetable oil inventory of Anthony De Angelis, making the collateral backing the loans nearly worthless and drastically affecting the confidence of the vegetable oil market as a whole. Soybean oil futures crashed by 30% in throughout the following week and the incident became known as The Great Salad Oil Scandal . A major difference between the salad oil scandal and the VLKAY or BP incidents was the fact that AXP’s large loss occurred in a non-core business which provided loans on warehouse receipts. AXP’s main business at the time was issuing traveler’s checks and their loan losses were immaterial in comparison to both the notional amount of traveler’s checks and the profits from the traveler’s checks business. AXP was never in danger on illiquidity (and thus, was safe from potential bankruptcy) so the large one-time loss provided an excellent entry point for Buffett to enter the stock. Buffett’s investment quickly recovered and AXP became a ten-bagger, providing a more than 1,000% gain. If your stock screener search outputs a quality company trading at low prices and your scuttlebutt research leads you to believe that the core business is not the cause for the low valuation, then you may have just found a homerun investment. Hopefully this article was a helpful reminder of how to view stock screener output for readers. Valuation metrics can only be a portion of any strong investment thesis. As investors, we should always remember that we are buying equity positions in real companies and not just fancy paper. I will provide a second part to this article in the coming days that will cover examples of some unique characteristics of equities. Some examples of what will be included in part 2 are uncommon features of stock classes, unique debt covenants, undervalued assets, and many more one-off situations to look out for. Below are the stock charts for VLKAY, BP, and AXP, which show the initial decline and the future results for resolved incidents: Volkswagen: (click to enlarge) BP : (click to enlarge) American Express: (click to enlarge) Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.