Beware Of Value Traps

| About: Chevron Corporation (CVX)

Summary

When a stock seems extremely cheap, there is usually a good reason behind it.

Investors who purchase stocks with low P/E ratios without fully understanding the market’s view are likely to incur excessive losses.

The article presents some cases in which premium stocks were trading at pronouncedly cheap valuations for no obvious reason. Investors found out the reason when it was too late.

According to Buffett, the most important determinant of our future returns is the price that we pay for a stock. Therefore, it is only natural that investors look for cheaply valued stocks. In addition, as the P/E ratio is the major proxy for the valuation of a stock, investors tend to look for stocks with pronouncedly low P/E ratios. Unfortunately for them, the market is so efficient in pricing stocks that, when a stock seems extremely cheap, there is usually a good reason behind it. To be sure, there are many stocks that were extremely cheaply valued by the market on the surface but later provided markedly negative returns to their shareholders. Even worse, there were not any alarm bells for an imminent deterioration of their business when they were cheaply valued. Therefore, investors should study some cases of such stocks, which are commonly described as value traps, in order to avoid similar losses in the future.

Chevron

Chevron (NYSE:CVX) looked surprisingly undervalued two years ago, when it was trading around $130, at a P/E ratio of only 11. Not only the company had an exceptional growth record but it was also heavily investing in huge growth projects, such as the Gorgon LNG project and the Jack St. Malo project. In addition, Chevron was a dividend aristocrat that was offering a 3% dividend yield at that time. Therefore, it is only natural that many investors considered it a great bargain back then.

Unfortunately, after trading around $100 for 4 years, oil was just about to experience one of its worst bear markets ever. Consequently, the earnings per share of Chevron collapsed, from $10.14 in 2014 to expected $1.16 this year. While the collapse of the oil price seems reasonable in retrospect given the boom of shale oil, the truth is that no-one predicted such a sustained dive of the oil price two years ago, when everyone thought that the $100 oil was the new norm. Therefore, the market was really wise when it attributed a low P/E to the stock near the top of its cycle, while many investors were allured by its seemingly cheap valuation.

Of course the same trend was observed with the other oil majors but I chose Chevron as an example because of its greater leverage on the oil price and the absence of other issues. For instance, BP (NYSE:BP) was also surrounded by the claims for its major accident in Macondo while Exxon Mobil (NYSE:XOM) has an equal exposure to natural gas and oil. It should be noted that the above mentioned pattern was much stronger in the cases of stocks that were much more leveraged to the oil price, such as the off-shore drillers. The graphs below depict the P/E ratio and the stock price of Chevron over time.

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Gilead Sciences

Gilead Sciences (NASDAQ:GILD) exhibited spectacular earnings growth, as it quadrupled its earnings in 2014 and further increased them by 62% in 2015 thanks to its all-star medicine Sovaldi. Therefore, it should have been surprising to many investors that this exceptional biotech giant was trading at single-digit P/E ratios in the last two years. In addition, the company was beating analysts' estimates quarter after quarter, thus continuously raising the bar for its performance.

However, the market had a different view. More specifically, the market was indicating that new competitors would soon enter the extremely profitable market of HCV and would thus drive the profits of Gilead Sciences down. This seems to be proving correct, as the company missed the analysts' estimates by a wide margin in Q1 for the first time in years. Thus the stock has lost 1/3 of its value off its peak while it still has negative momentum. Of course if the company manages to come up with a new all-star drug like Sovaldi, that will be a game changer and the stock will rally back to its peak. However, this is a totally different issue. The point of the article is to show that the market had a very good reason when it was valuing the stock surprisingly cheaply and, even worse, there were absolutely no negative signs for the business performance of the company back then.

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Copa Airlines

Buffett has repeatedly advised investors to stay away from airline stocks, as they are highly cyclical and hence a rough year can erase many years' profits. That's why several airlines have gone bankrupt in the last two decades. Nevertheless, Copa Airlines (NYSE:CPA) seemed to be a bright exception to the rule. To be sure, the company generates most of its earnings in Panama and other countries of Latin America, where there is limited competition, while the company also enjoys a favorable tax regime compared to its peers. Thus the company had consistently grown its earnings for years.

Therefore, it should have been surprising to many investors that the stock was trading at just 10 times its earnings about two years ago. The only issue at that time was the effect of the capital controls in Venezuela, which prevented Copa Airlines from using the cash it had in the country. That issue seemed to be a non-recurring headwind and hence the stock seemed to be a great bargain back then. Unfortunately, things turned out differently. More specifically, the whole region of Latin America stopped enjoying high growth rates while the currencies of most countries incurred extreme devaluation. Consequently, despite the gift from the collapse of the price of jet, the earnings of Copa Airlines plunged by about 50% last year and are expected to dive further this year. Therefore, again the market proved very wise when it valued cheaply the stock near the top of its business cycle.

Conclusion

The above cases confirm that the market usually has a good reason for its valuation when a stock seems surprisingly undervalued on the surface. This is particularly true when premium companies, like the above mentioned ones, trade at pronouncedly low P/E ratios. There are also several other similar cases, such as those of International Business Machines (NYSE:IBM) and Fossil (NASDAQ:FOSL). Of course there will be times when the fears of the market will prove overblown and the stocks will eventually rally. Nevertheless, investors should certainly perform their due diligence and make sure they clearly understand the reasons behind the cheap valuation. If they purchase stocks with low P/E ratios without fully understanding the market's view, they are likely to incur excessive losses.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.