Cheap For A Reason? Beware The Value Trap

by: Invesco PowerShares

Summary

Cheap stocks can be compelling investments, but can also mask underlying problems with issuers.

A value trap happens when investors buy attractively valued stocks, only to see poor company fundamentals depress prices further.

Combing the value and momentum factors can help avoid value traps by screening out stocks with poor price momentum.

Combining value, momentum factors can help avoid hidden dangers of inexpensive stocks

By Nick Kalivas

The idea of purchasing stocks that are inexpensive relative to their peers, or to their intrinsic value, can make value investing an attractive investment strategy. After all, value has a well-earned reputation for being a rewarded factor, with famous investors like Benjamin Graham and Warren Buffett known for their value-based investment approaches. Value is also grounded in academic research. The groundbreaking Fama-French Three Factor Model incorporates value, along with the size and market factors, to help portfolio managers improve the security evaluation process.

What is a value trap?

While value can be an appealing investment strategy, identifying value opportunities is not as easy as it might appear. One of the drawbacks of value investing is the so-called "value trap." A value trap occurs when a stock appears cheap, but is trading at low multiples due to underlying problems with the stock's issuer. In other words, the stock is cheap for a reason and could trade even lower in the future. Changing industry conditions, secular shifts in technology, and management miscalculations can lead to value traps. Further, some valuation measures may be backward-looking when the market is pricing the future.

Value traps are real. Let's take a look at two examples:

Value trap: Target

Value trap: Target

Source: Bloomberg L.P., as of March 31, 2017

With only a few exceptions, between January 2011 and February 2016, Target's (NYSE:TGT) price-to-earnings (P/E) ratio ranged within two points of the P/E ratio of the S&P 500 Index. However, in the spring of 2016, Target's P/E ratio started moving lower, with its ratio spread to the S&P 500 Index widening to 6.5 by October 2016. Judging by its discounted P/E ratio, Target stock appeared inexpensive - a "value" to the broader market. At the close of October 2016, Target shares were priced at $68.73. Despite this discounted P/E ratio, however, Target's stock went on to fall an additional 20% to $55.19 by March 2017. By contrast, the S&P 500 Index rose 11.1% over this same period, leading to a yawning P/E discount of 10.77.

In retrospect, Target's valuation compression appeared linked to competitive pressures, a long-term trend toward online shopping, and changing consumer preferences and buying habits. Whatever the reason, Target's stock price decline in the face of a low P/E ratio illustrates how difficult and risky ascertaining real value can be.

Value trap: The energy sector

Value trap: The energy sector

Source: Bloomberg L.P., as of March 31, 2017

Another interesting case of a value trap can be found in the energy sector. (Given the high volatility of energy P/E ratios, I use price-to-book ratios in this example.) On a price-to-book basis, the spread between the S&P 500 Index and the S&P 500 Energy Index went from 0.10 in April 2011 to -1.04 by the end of January 2015. Despite these low valuations, the price of the S&P 500 Energy Index retreated another 24% over the ensuing 12 months. So, even though the energy sector had become more attractively priced, energy prices continued to drop - again highlighting the difficulty in discerning value. By contrast, the S&P 500 Index declined only 3.1% across this same period.

The energy sector's valuation compression was based on the surprising weakness in oil prices, which are a key determinate of energy company revenue and profitability. Front-month West Texas Intermediate crude oil futures were priced at over $100 per barrel in June 2014 and had plunged to less than $35 per barrel by March 2016. The increased use of fracking - a disruptive technology change - played a key role in the energy sector's value trap. Even though fracking was not a new concept in 2014, its impact on production, coupled with an ongoing economic slowdown, contributed to valuation compression within the energy sector.

Overcoming value traps

One way to overcome value traps may be to combine the value and momentum factors. This is because the value factor can screen for stocks that are attractively priced, while the momentum factor looks for stocks that have recently demonstrated strong risk-adjusted returns, which may help reduce the probability of buying into a value trap. Rising value stocks may be a sign that value is being unleashed and a stock is moving toward its intrinsic value.

Of course, there is always the risk that momentum stocks fall out of favor as market conditions shift. Companies can report bearish business developments that can reverse a positive price trend and catch investors leaning the wrong direction. Moreover, the momentum factor can struggle during periods where investors are reducing risk and asset returns are highly correlated.

The momentum factor may also provide an opportunity to manage risk. This is because value stocks showing poor momentum can be removed from a portfolio (depending on when it reconstitutes), reducing the chances of continuing to hold a value trap.

Investors interested in the combination of value and momentum may wish to consider the PowerShares S&P 500 Value With Momentum Portfolio (BATS:SPVM), which combines the momentum and value factors and is rebalanced and reconstituted semiannually.

All data from Bloomberg L.P., as of March 31, 2017.

Important information

Blog header image: Marco Uliana/Shutterstock.com

Past performance cannot guarantee future results.

Price-to-book ratio is calculated by dividing the market price of a stock by the book value per share.

Price-to-earnings ratio, also called multiple, measures a stock's valuation by dividing its share price by its earnings per share.

The S&P 500 Energy Index comprises those companies included in the S&P 500 Index that are classified as members of the GICS energy sector. An investment cannot be made in an index.

The momentum factor focuses on companies that exhibited the highest performance over the past 12 months, excluding the most recent month, and risk-adjusts the momentum score based on volatility over the period. The value factor focuses on stocks with low price-multiple ratios (price-to-book, price-to-earnings and price-to-sales).

West Texas Intermediate (WTI) is light, sweet crude oil commonly referred to as "oil" in the Western world.

There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The fund's return may not match the return of the underlying index. The fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the fund.

Momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole or returns on securities that have previously exhibited price momentum are less than returns on other styles of investing.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

The fund is nondiversified and may experience greater volatility than a more diversified investment.

Investments focused in a particular industry or sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

Before investing, investors should carefully read the prospectus/summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the funds, call 800 983 0903 or visit powershares.com for a prospectus/summary prospectus.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.'s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. PowerShares® is a registered trademark of Invesco Ltd., used by the investment adviser, Invesco PowerShares Capital Management LLC (PowerShares) under license. PowerShares and Invesco Distributors, Inc., ETF distributor, are indirect, wholly owned subsidiaries of Invesco Ltd.

©2017 Invesco Ltd. All rights reserved.

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

Business relationship disclosure: This article was posted on the Invesco PowerShares' blog by an Invesco PowerShares' employee on April 26, 2017: https://www.blog.invesco.us.com/cheap-stocks-beware-value-trap

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