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Retail Value Traps and Value Plays

NEW YORK (TheStreet) -- Retail stocks can be very enticing due to how undervalued the shares can appear. As an example, Sears (SHLD - Get Report) now has a price-to-sales ratio of around 0.12. That means that every dollar of sales is discounted by almost 80% in the stock price.

Here are three ways for investors to tell the difference between a value trap and a value play for retail stocks.

A value trap is when financials such as the price-to-sales ratio and price-to-book appear to be so compelling that investors buy and "catch a falling knife," losing money in the end. Value plays are what made Warren Buffett rich: assets in which the market is inefficiently pricing so the cost is below its intrinsic worth. That can be for a variety of factors that could range from the sector being out of favor to the chief executive mismanaging the company to bad news temporarily driving the price down.

When the price-to-sales ratio and price-to-book ratio appear low, it's bullish if sales growth and earnings-per-share growth are improving with the company making money. That is the present case with Sony (SNE). (It is not the case with Sears, J.C. Penney (JCP) and Bon-Ton Stores (BONT).) The companies bought merchandise that is not selling so it appears to be worth more than it is due to accounting, creating a value trap.

Must Read: Cash Dividend On The Way From Banco Santander SA's Non-Cumulative Series 5 Guaranteed Preferred Securities

That brings up the cash conversion cycle.

This is a critical indicator for a retail company as it measures in days how long it takes for inventory to sell. For a well-run company, it will be short. That will show that management knows what the consumer wants. Wal-Mart (WMT) has a cash conversion cycle of 90.1 days. For Sears, it is 105 days, almost 20% worse. The cash conversion cycle for Bon-Ton Stores is 111 days. J.C. Penney has a cash conversion cycle of 130 days, taking nearly 50% longer to move its products than Wal-Mart.

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