Cheap stocks can be a bargain, yielding hefty returns as they bounce back. Yet in hunting for those opportunities, investors sometimes find themselves holding stocks that are cheap for a reason and aren’t likely to recover in the foreseeable future—so-called value traps.
Value traps often appear when a company’s stock price and fundamental metrics are both deteriorating, but the shares are dropping faster, creating the impression that the stock is cheap. If the valuation continues to erode, some investors will buy even more in order to take advantage of the lower price, eventually winding up with big losses.
“People have a tendency to keep thinking, if the price is going down, it’s even better now than it was before, and they sometimes don’t go back and look at what is going on with the fundamentals.” says Rob Waldner, a strategist at Invesco. In behavioral science, this is called “confirmation bias.”
When picking potentially undervalued stocks, therefore, it’s always important to look at the fundamentals of a company and make sure its business is healthy.
There are plenty of ways to go wrong. A company with lots of assets on its books may not be generating revenue. Huge sales numbers can be based on a money-losing business model and negative profit margins. Even firms with strong earnings growth may be loaded with debt.
In good times, companies with debt aren’t necessarily value traps, explains Thomas Cole from Distillate Capital, but indebtedness can drag a company over the edge when things are going in the wrong direction. “When debt coverage becomes an issue, equity valuation can become very dynamic.” Cole told Barron’s over the phone.
That is why the ability to generate cash is the one factor, among all the fundamental metrics, that some value managers watch the most closely. “We like companies that can generate a lot of free cash flow,” says Michael Mullaney from Boston Partners. “Basically they can self-fund themselves. They don’t have to go to the bond market or the equity market.”
If things don’t seem that rosy, at least some improvement should be visible. “We have to see definitive momentum in the fundamentals before we jump on board to buy a stock,” he says. “Or if we think there is a catalyst out there, such as a merger and acquisition, something that’s going to unleash value and help us avoid value traps.”
Sometimes, problems go beyond the scope of an individual company. A whole industry may be going downhill, struck by technological disruptions and changes in consumer behavior such as the shifts that allowed mobile phones to replace landlines, and online streaming to snuff out the DVD rental business.
The final thing to watch? Don’t fall for the “lottery effect”—buying stocks at extremely cheap prices and hoping to reap huge gains if the company can turn around a bad situation. It’s not that those recoveries never happen, but academic research has shown that when a big payoff is at stake, people tend to overpay for the actual odds of winning. In other words, it’s just not a good deal.
For most investors, maybe the best way to avoid value traps is to avoid picking individual stocks by themselves. Many mutual funds and ETFs that invest in value stocks use fundamental metrics in their screening processes. They could offer a good safety net.
iShares Edge MSCI Multifactor USA ETF
(ticker: LRGF) and
Vanguard U.S. Multifactor ETF
(VFMF), for example, select stocks that exhibit solid fundamentals and strong recent performance, but also trade at lower prices relative to fundamentals. Earlier this year, DWS Investments also launched the
Xtrackers Russell 1000 US QARP ETF
(QARP), which seeks out high-quality companies that aren’t priced too high. The fund is still fairly new, with only $66 million in assets under management.
For fixed-income investors that want a similar solution, Invesco launched two funds on Thursday: the Invesco Multi-Factor Defensive Core Fixed Income ETF (IMFD) and the Invesco Multi-Factor Income ETF (IMFI). Both look for bonds with attractive yields and favorable maturities term and credit rating, but with different emphases on quality and value. The Defensive Core Fund tilts more toward less risky debt, while its counterpart leans toward potentially undervalued securities.
It’s always the best to find the sweet spot in between.
Write to Evie Liu at email@example.com