Don't Touch These 5 Huge Value Traps

With the S&P 500 still down some 30% since its 2007 high, some folks are wondering whether it's time to take advantage of the bargains still in the market.

So the urgent question is: Does buying beaten-down stocks actually lead to riches?

The shocking truth
To evaluate the merits of a contrarian approach to the market today, I recently ran a screen to discover how well a similar tactic would have worked during the previous recession. I divided all 278 large-cap stocks into five groups by performance over that period, and looked at how well they did over the following five years.

Here's what I found:

Quintile

Performance,
 March-November 2001

Annualized Performance,
November 2001-November 2006

1

 (51.3%)

6.1%

2

 (25.1%)

6.5%

3

 (13.4%)

9.1%

4

 (3.6%)

3.9%

5

 9.6%

9.2%

Total

 (16.9%)

7.1%

Data courtesy of Capital IQ, a division of Standard & Poor's.
Stocks trading on major U.S. exchanges capitalized at more than $10 billion on March 1, 2001.

As you can see, stocks that had been scorched the most over that blistering eight-month period actually underperformed those that had done just fine -- by 3.1 percentage points annually!

How'd that happen?
Over those painful eight months, the market had correctly anticipated the value of many of these large companies, and discounted them accordingly. A 50% haircut is certainly a markdown -- but it's not necessarily a sale, especially if the value of the company has been cut in half, or was overvalued to begin with.

The savviest investors know that willy nilly "contrarianism" isn't a sure path to riches. As the financial disasters of the past few years illustrate, companies often get punished for all the right reasons. And in those cases, their plight can be as bad as you think -- and worse.

The envelope, please
Here are the names of five huge companies that are likely to be value traps. All five have had massive declines, which make shares appear tempting to investors. However, they are also:

  • Heavily scrutinized large companies.
  • Among quintiles whose performance was anemic in the latest recessionary go-round.
  • Rated one or two stars, the lowest ratings, by our Motley Fool CAPS community.

Company

Prerecession Market Capitalization
(in billions)

Return Since Beginning of Recession

Analyst Coverage

Las Vegas Sands (NYSE: LVS  )

$40.3

(74%)

23

Motorola (NYSE: MOT  )

$36.5

(52%)

33

Dell (NYSE: DELL  )

$54.9

(52%)

39

Regions Financial (NYSE: RF  )

$18.4

(75%)

22

Macy's (NYSE: M  )

$12.8

(34%)

16

Data from Motley Fool CAPS and Capital IQ, a division of Standard & Poor's.
According to the National Bureau of Economic Research, the recession began Dec. 1, 2007.

Yes, shares of these companies have fallen dramatically, but only because they've dealt with massive deleveraging, deteriorating business lines, awful competitive dynamics, and/or managerial missteps in the face of an already ugly economic period.

Given the amount of attention these companies generate on Wall Street (as illustrated by the final column, analyst coverage), there's a strong chance that the sell-off was justified.

Should you short them?
Sure, these stocks might be not the best places to invest today, but I wouldn't necessary suggest shorting them. A few might have the potential to turn things around, surprising short investors.

If shorting is something that interests you, however, it's important to identify companies with major competitive disadvantages and, if possible, suspicious accounting in addition to operating difficulties. Because you want to gather insights that other investors might not have.

If you're interested in identifying troubled stocks, enter your email address in the box below to get a free copy of "5 Red Flags -- How to Find the Big Short," a new report from my colleague John Del Vecchio, CFA, a leading forensic accountant. The report is free -- simply enter your email in the box below.

This article was originally published Aug. 7, 2008, under the headline "Don't Touch These 3 Huge Value Traps." It has been updated.

Ilan Moscovitz doesn't have a stake in any company mentioned. The Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (6)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 30, 2010, at 11:47 PM, RegLeCrisp wrote:

    Del Vecchio must be sending lot of green your folks way, every other article is on shorting or hints strongly at it.

  • Report this Comment On August 31, 2010, at 11:50 AM, CPACAPitalist wrote:

    I think its good that TMF is giving shorting some attention. Its not the way that I choose to invest, but it's a major strategy that deserves some discussion at a minimum.

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