Here's how to identify a bad stock.

Value investors are perpetually on the hunt for stocks that are underpriced based on the underlying company’s performance. However, sometimes traditional value investing metrics such as a price-earnings ratio don’t paint the full picture of what’s going on with a company. Former Kase Capital hedge fund manager Whitney Tilson recently outlined a number of traits that are hallmarks of “value trap” stocks. Tilson says not all value stocks are created equal, and failing to recognize all the subtle warning signs can devastate an investing portfolio. Here are eight traits that help identify losing stocks.

Next:It has an unsustainable business practice. Credit

(Christopher Furlong/Getty Images)

It has an unsustainable business practice.

Turnaround stories can be excellent investment opportunities. For example, by the end of 1998, Apple (ticker: AAPL) shares had declined nearly 80% from its 1992 high. Of course, the launch of the iPod and iPhone completely changed Apple’s trajectory and paid off huge for patient investors. Tilson says investors should determine whether or not a company’s business is ultimately doomed. Stocks like Eastman Kodak Co. (KODK) can remain profitable and seemingly undervalued for years as the underlying business slowly dies. All the value metrics and brand strength in the world couldn’t save Kodak from the disruption of the smartphone.

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Here's how to identify a bad stock.

Value investors are perpetually on the hunt for stocks that are underpriced based on the underlying company’s performance. However, sometimes traditional value investing metrics such as a price-earnings ratio don’t paint the full picture of what’s going on with a company. Former Kase Capital hedge fund manager Whitney Tilson recently outlined a number of traits that are hallmarks of “value trap” stocks. Tilson says not all value stocks are created equal, and failing to recognize all the subtle warning signs can devastate an investing portfolio. Here are eight traits that help identify losing stocks.

It has an unsustainable business practice.

Turnaround stories can be excellent investment opportunities. For example, by the end of 1998, Apple (ticker: AAPL) shares had declined nearly 80% from its 1992 high. Of course, the launch of the iPod and iPhone completely changed Apple’s trajectory and paid off huge for patient investors. Tilson says investors should determine whether or not a company’s business is ultimately doomed. Stocks like Eastman Kodak Co. (KODK) can remain profitable and seemingly undervalued for years as the underlying business slowly dies. All the value metrics and brand strength in the world couldn’t save Kodak from the disruption of the smartphone.

There is legal or regulatory scrutiny.

Tilson’s most noteworthy short call of his investing career has been Lumber Liquidators Holdings (LL). Lumber Liquidators shares famously crashed from its all-time high of $115 in 2013 to $12 by August 2015 after Tilson was featured on a “60 Minutes” episode detailing illegal practices by the company. Tilson received a tip that Lumber Liquidators was using laminate tainted with formaldehyde in its China factories. After investigating the issue, he brought it to light on the “60 Minutes” episode, which tanked the stock. Companies exposed to legal or regulatory risks can be extremely difficult to accurately value given the uncertainty.

It is exposed to technological disruption.

Sears Holdings (SHLDQ) is a great example of a powerful and valuable brand that relied on a business model that became outdated thanks to Amazon.com (AMZN) and the e-commerce revolution. Just because technological innovation threatens a company’s business doesn’t necessarily mean the stock is doomed. Netflix (NFLX) originally operated as a DVD-by-mail company. However, Netflix quickly pivoted to streaming video and thrived, whereas competitor Blockbuster went down with the DVD ship. Technology will always change the business world. Investing in companies that aren’t keeping up is a losing strategy, no matter how cheap the stocks look at first glance.

There is questionable accounting.

“Accounting” is one of the few single words that can immediately tank a stock just by appearing in a news headline. Enron and WorldCom are classic examples of outright accounting fraud. However, investors don’t need to wait around for executives to be hauled off in handcuffs. When there’s smoke, there’s often fire. Even if a company is not committing outright fraud, those abusing accounting laws to deceive or mislead investors often make for bad investments as well. General Electric Co. (GE) stock is down 70% in the past three years due in part to its misleading accounting.

New competitors entered the space.

When a company is the first to tap into a new market, it doesn’t have to be perfect to capture a significant portion of the market share. However, while a so-called first-mover advantage is significant, a company must be able to fend off new competitors to survive. Tilson says Tesla (TSLA) investors may soon fall victim to this shortcoming. Tesla established a dominant early lead in the electric vehicle market. However, Tilson says legacy automakers with large-scale infrastructure and massive amounts of resources will soon be attacking Tesla from all angles with their own EV models.

There is a one-time event.

P/E and price-sales ratios are typically calculated annually. If a company gets a temporary EPS boost in one quarter, the impact could improve its valuation metrics for a year. On the surface, the 2018 tax cuts generated impressive earnings growth numbers, but one-time tax cuts have nothing to do with underlying organic earnings growth. If a company reports a suspiciously high earnings number, do some digging to see what’s actually behind the big number. An earnings boost from the launch of a new product is much more bullish than an earnings boost from a one-time asset sale.

It could be part of a cyclical business.

Some businesses are prone to cyclical extremes. During market upswings, these stocks often trade at extremely low earnings multiples because investors are already anticipating the impact of the next downturn. Companies that rely on discretionary spending typically have earnings cycles closely tied to the U.S. economy. For example, airline stocks such as Delta Air Lines (DAL) and American Airlines Group (AAL) currently have extremely low earnings multiples. The airline business is booming in a red-hot economy, but airlines have struggled to stay profitable during past economic downturns. These stocks are valued with the expectation that peak earnings will not last.

It could be part of a fad.

Looking back at family photos from 20 years ago can reveal some pretty embarrassing fashion and hairstyle choices. Buying into temporary investment fads on Wall Street can be just as embarrassing and much more costly. Snapple tea, Crocs (CROX) shoes and cryptocurrencies like bitcoin are three examples of investments that were red-hot when the fad was popular and then went ice-cold when the fad didn’t last. Sometimes, it can be difficult to identify a fad from a new long-term market trend. However, fad companies typically have very limited product or service offerings that are easily emulated by competitors.

Traits of a losing stock:

It has an unsustainable business practice.There is legal or regulatory scrutiny.There is exposed to technological disruption.There is questionable accounting.New competitors entered the space.There is a one-time event.It could be in a cyclical business.It could be part of a fad.1 of 11

Wayne Duggan, Contributor

Wayne Duggan has been a U.S. News & World Report contributor since 2016. He is an expert at ...  Read more

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