Avoid The Snap Of that Value Trap
Animal traps come in two types. One is designed to drive or spook the animal to do something it wouldn't normally do, and thus end up in the trap. The rest rely on the animal behaving naturally, catching it in the process of moving or searching for food.
Stock investors can fall into both types of traps. Regular readers of the Forecasts should know better than to change their approach without good reason, such as panic-selling at the first hint of bad news. However, traps that snare investors doing what they're supposed to do are more insidious. Today we focus on probably the best known of these, the value trap.
Investors fall prey to value traps because they're following the rules, looking for stocks trading at a discount to the market or to their peers. Value-investing strategies make sense. Stocks with high Quadrix Value scores (earned via low price/earnings, price/book, and other valuation ratios) tend to outperform. The rationale is that over time, the market will bid up stocks with unusually low valuations. But some stocks are cheap for a reason, and we call those value traps.
Spotting value traps
Think you've found a bona fide value? Here are four ways to tell a value stock from a value trap:
• Lack of growth. Most investors expect the companies they own to boost sales and profits over time. Companies that don't grow, or that grow slower than their peers, often trade at a discount — one that can persist for a long time. For example, the insurer Genworth Financial ($8; GNW) earns a Quadrix Value score of 100. However, its lack of growth (five-year annualized decline of 1% in sales and an operating loss, compared to a profit five years ago) contributes to a mediocre Overall score.
• Business troubles. Markets look forward, and if looming developments could crimp operating results, you should expect investors to react by giving a stock — or even its entire industry — a valuation that looks cheap, but only at first blush.
Concerns about rising interest rates and low profit growth weigh on electric-utility stocks, which now average a trailing P/E ratio of 16 and a Value score of 71. While the industry as a whole may smell like a bargain relative to the broad market, electric utilities aren't as cheap as they seem.
• Industry comparison. Relative to the broad market, American Express ($79; AXP) looks like a steal. At 14 times trailing earnings, it trades at a deep discount to the average P/E ratio of 22 for S&P 1500 Index stocks.
However, the average consumer-finance stock trades at just 11 times trailing earnings, 17% below Amex's valuation. Amex also comes up short of industry norms on near-term growth; its Momentum score of 38 lags the industry average of 52.
• Fat yields. This one is counterintuitive because, all else equal, a high yield is better than a low yield. But as experienced investors understand, all else is rarely equal. Yield often represents a proxy for risk, as stocks with poor prospects must pay larger dividends to attract investors. When you spot a stock like Xerox ($10; XRX), with a 2.7% yield more than double the average for its industry, don't assume you've uncovered a gem everyone else overlooked.
Xerox earned its cheap valuation (just 10 times trailing earnings) with a negative return of 23% over the last six months. Sales, profits, and operating cash flow have declined in the 12 months ended March, and the consensus projects sales and profit declines for 2015. Don't be fooled by the Value score of 97.
We use our Quadrix stock-rating system to ferret out value traps, mostly by limiting ourselves to stocks with high Overall scores, which screens out companies with weak fundamentals. But there are other ways to spot a value trap, as shown above.
At 15 times trailing earnings, Ameriprise Financial ($126; AMP) trades 31% below the average of 21 for asset-management stocks in the S&P 1500 Index. The stock's Value score of 89 tops the industry average by 27 points, and only one rival earns a higher score. Over the last three months, Ameriprise delivered a negative total return of 1%, in line with the industry average, as asset managers have been hurt by worries about the broad stock market. Don't mistake that price weakness for a reflection of operational troubles.
One reason we see Ameriprise as a value and not a value trap involves its growth history. The company has increased sales in 11 consecutive quarters, while per-share profits rose in nine of the last 10 quarters, averaging growth of 42%. Analysts expect Ameriprise to continue boosting earnings, with the consensus projecting at least 11% growth in the June and September quarters and full-year 2015 and 2016. The company plans to release June-quarter results after the market closes on Wednesday, July 22. Ameriprise, yielding 2.1%, is a Focus List Buy and a Long-Term Buy.
J.P. Morgan Chase ($69; JPM) earned $1.54 per share in the June quarter, up 5% despite a 3% decline in sales. Both profits and sales topped the consensus. Higher profits at the corporate and investment bank offset declines at the com-
mercial-banking and asset-management units. Lower legal costs boosted profitability.
J.P. Morgan is among the cheaper stocks on our buy lists, with a trailing price/earnings ratio of 12, 23% below the average for diversified banks. The stock's dividend yield of 2.5% is generous, but not high enough to warrant suspicion. While a series of high-profile and even higher-dollar fines and settlements have dragged on J.P. Morgan in recent years, the worst seems to be over.Â
Earlier this month, the financial giant agreed to pay more than $200 million in fines and refunds, plus overhaul its credit-card collection process, as part of a settlement with state and federal governments. In response, the shares fell 2.1% on a day when the S&P 500 dipped 1.7%. While we'd rather see no legal issues at all, the market's ho-hum reaction to the latest settlement suggests investors aren't especially worried. J.P. Morgan is a Buy and a Long-Term Buy.
Over the last 12 months, Lear ($104; LEA) posted growth of 7% in sales, 59% in per-share profits, and 30% in operating cash flows. The maker of auto parts has topped analyst expectations in 14 consecutive quarters, and the consensus projects per-share-profit growth of 18% this year, 14% next year, and 16% annually over the next five years.
If this doesn't sound like the portrait of a value trap, you're seeing the same thing we see. Yet Lear earns a Value score of 94 and trades at just 12 times trailing earnings, 30% below the industry average.
The specter of a slowdown in car demand (and thus production) has contributed to Lear's price decline in recent weeks. However, recent disappointing rumbles from China aside, the world as a whole is becoming wealthier, a long-term trend that bodes well for auto sales. Focus List Buy and Long-Term Buy Lear, yielding 1.0%, is expected to release June-quarter results on July 24.
Southwest Airlines' ($34; LUV) trailing P/E ratio of 14 is lower than the average for airlines in the S&P 1500, but only by the narrowest of margins. While such a valuation doesn't sound impressive on the surface, over the last five years Southwest has averaged a P/E ratio 46% above its average peer. Southwest has been cheaper than the industry average in just eight of the last 120 months. Factor in a Value score of 91 (versus 81 for the industry), and Southwest looks surprisingly cheap, even in an industry with weak stock performance.
Several airlines, including Southwest, have forecast a decline in revenue per available seat mile (RASM), reflecting aggressive expansion industrywide. However, Southwest rallied last week when rival American Airlines Group ($42; AAL) lowered its 2015 target for capacity growth. Analysts expect Southwest's per-share profits to rise 66% this year, followed by 1% in 2016; next year's profit target seems unduly low. Southwest, a Long-Term Buy, is slated to declare operating results July 23.