Energy: A Value Trap - Merrill

Since we're talking value investing today with Columbia University's value guru Bruce Greenwald, it's a good time to point out one of the big risks associated with buying shares in out-of-favor companies: The value trap.

"Value trap" is the name given to a stock that has fallen heavily, but is still going lower as fundamentals in the businesses weaken further. They're just the sort of stocks that tend to go down hard and stay down longer even when they look cheap. Friday, Merrill Lynch sent out its monthly list of value trap industries, and as of Friday that list includes the beaten-down energy sector.

Merrill's value trap list:

• Electronic Equipment & Instruments
• Energy Equipment & Services*
• Independent Power Producers & Energy Traders
• Industrial Conglomerates*
• Insurance Machinery*
• Metals & Mining*
• Personal Products*

While there might be great value-friendly names in all of the above, the risks of making a bad bet on a value stock can have some costly consequences. From Merrill (bold is mine):

These are industries with attractive value characteristics but deteriorating price momentum and earnings outlooks. Industries with above average valuation rank, but below average earnings and price momentum ranks, have tended to stagnate in the same category. Their price momentum and earnings expectations further trend down. Typically a catalyst is necessary to move these industries from this value trap category of the model. Sixty-seven percent of the time, these industries either remain value traps or their deteriorating fundamentals cancel out their undervaluation altogether and they fall even further in the model.

Also, Merrill has a warning for value folks salivating at all the current devastation: Don't get ahead of yourself.

Our work suggests that the hardest thing for a value manager to do is to buy a stock, and good value-oriented managers are likely to be buying stocks later than their peers. Value managers often like to say that they will buy stocks early but they’ll be there at the bottom. Although that sounds encouraging, the route to value fund underperformance is to buy early too many times.

Comments

[Al in Oregon:]

What is "Insurance Machinery"? I've been an investor for decades and I've never heard that term. I have no clue as to what that is.

2008 Nov 08 01:24 PM

[investor88:]

Most interesting article. Energy a value trap, may well be! Going one step further, isn't the broad equity market [ and other asset markets ] a value trap too in the light of deteriorating fundmentals?

2008 Nov 09 09:14 AM

[Jimbo:]

I would like t o know what "insurance machinery" is as well.

2008 Nov 09 11:45 AM

[Dr. Duru:]

I agree with "investor88" - based on this list (minus insurance machinery), the broader stock market is likely a value trap. Would have been interesting for Merrill to accompany their value trap sectors with sectors that they consider investable now.

On Nov 09 09:14 AM investor88 wrote:

> Most interesting article. Energy a value trap, may well be! Going
> one step further, isn't the broad equity market [ and other asset
> markets ] a value trap too in the light of deteriorating fundmentals?

2008 Nov 09 11:58 AM

[Steven Ward:]

The price of oil and the price of NG goes lower then a value trap otherwise buy here if you think we have bottomed.

Baron Rothschild said it best " I'm not so concerned about buying at the bottom 10 percent of the market or selling at the top 10 percent of the market, it is the 80 percent in between that concerns me"

We can all afford to wait and watch.

2008 Nov 09 12:46 PM

[erewhonman:]

Is he saying 'bear markets go down' and bulls, of course, go up. While the 'two-thirds' number seems pulled from a hat, it is consistent with momentum notions - momentum takes you in the direction its going! Big words describing well known phenomena

2008 Nov 09 12:56 PM

[yank:]

We are going to take "value" advice from a company (Merrill) that pushed itself to the brink of bankruptcy? Don't think so. Let us all remember that it was Merrill Lynch that:

1. Closed up its commodity trading in 2001 (right before commodities exploded higher by triple digits).
2. Recommended selling all precious metals positions in 2002 (right before gold/silver took off on a 200% gain).
3. Predicted in 2002 that oil would remain cheap in the $20 range for the indefinite future.

So, you want me to believe anything that Merrill Lynch has to say? If anything is a "value trap" today it is the BROKERS. Operating with a flawed business model, undercapitallized, and with mistrust of their financial reporting, brokers are a trap that all investors should avoid for the foreseeable future.
Unlike the brokers, the oil companies actually produce something of value that is needed by this society. Quite simply oil companies and others in the energy complex are currently priced as if they were going bankrupt. I hate to break it to you but XOM, CVX, and OXY are not going bankrupt anytime soon. But Merrill Lynch, that's another story..............

2008 Nov 09 03:02 PM