Energy: It's a Value Trap

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. Today, Merrill Lynch sent out its monthly list of value trap industries, and as of today 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.

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