Don't Touch These 3 Huge Value Traps

"Valuations are starting to get silly."

These were the words spoken by the chief investment officer at a major commercial bank during a recent call on the state of the economy.

With the S&P 500 down nearly 11% year to date, shares of even stable blue chips cratering, and investors scared witless, others are wondering if it's time to take advantage of some great bargains.

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 last recession. I divided all 278 large-cap stocks into quintiles 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 2001-Nov. 2001

Annualized Performance Nov. 2001-Nov. 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%

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

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 not necessarily a sale, 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 financial disasters Washington Mutual (NYSE: WM  ) , National City (NYSE: NCC  ) , and JPMorgan's (NYSE: JPM  ) prey Bear Stearns 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 three huge (market caps of $10 billion or more) companies I believe are value traps. All three have had massive declines in the past year, which make shares appear tempting to investors. However, they are also:

  • Heavily-scrutinized large caps
  • Among quintiles whose performance was anemic the last recessionary go-around
  • Rated one star, the lowest possible rank out of five, by our CAPS community

Since we began tracking the collective intelligence of our CAPS investment community in November 2006, one-star companies have fared poorly, with an average annualized loss of 11.4%.

Company

Market Capitalization

Analyst Coverage

52-week Return

Capital One Financial (NYSE: COF  )

$16 billion

19

(35%)

Lehman Brothers (NYSE: LEH  )

$13 billion

19

(64%)

Merrill Lynch (NYSE: MER  )

$26 billion

19

(61%)

Data from Motley Fool CAPS and Yahoo! Finance.

Yes, shares of these companies have fallen dramatically, but that's because they've dealt with massive write-downs, deteriorating business units, managerial missteps, and CEO firings in the face of an already ugly economic period.

Given the amount of attention these massive companies generate on Wall Street (as seen in that third column, "Analyst Coverage"), there's a strong chance that the sell-off was justified. If history is to repeat itself, thrashed large caps are not going to be the best stocks to buy now. If you want to profit from the recent marketwide sell-off, you need to look where others aren't.

A contrarian contrarian strategy
This time I compared the post-recession returns of the aforementioned 278 large caps to the performance of 1,740 smaller companies. I had expected some disparity in their five-year returns, but its sheer size was astounding:

Quintile

Small-Cap Performance, March 2001-Nov. 2001

Small-Cap Annualized Performance, Nov. 2001-Nov. 2006

Large-Cap Performance, March 2001-Nov. 2001

Large-Cap Annualized Performance, Nov. 2001-Nov. 2006

1

(53.8%)

23.7%

 (51.3%)

6.1%

2

(19.8%)

16%

 (25.1%)

6.5%

3

(1.4%)

14.5%

 (13.4%)

9.1%

4

14.7%

14.3%

 (3.6%)

3.9%

5

57.3%

13.7%

 9.6%

9.2%

Total

(0.7%)

16.7%

 (16.9%)

7.1%

Companies capitalized between $100 million and $2 billion versus those capitalized at more than $10 billion on March 1, 2001. Data courtesy of Capital IQ, a division of Standard & Poor's.

A small-cap contrarian approach following the last recession would have paid off handsomely, turning a $10,000 investment into nearly $30,000 in just five years. But not only did the most beaten-down small caps outperform their spared peers, every quintile of small caps outperformed every quintile of large caps over the following five years.

In fact, every single one of the top 10 stocks since the last recession was a small or mid cap. The very largest among them was an unappreciated $6 billion computer hardware maker destined for greatness named Apple (Nasdaq: AAPL  ) .

Not only have recent years have been an exceptionally great time to own small caps, a number of studies have shown that over the long haul, small caps outperform larger companies. According to research from professors Fama and French, small-cap value stocks outperformed their larger counterparts 17.3% to 13.3% on average from 1956 to 2005.

That's because small caps tend to be less closely watched by big brokerage houses and the financial media, so their stock prices are more likely to behave irrationally -- and provide huge opportunities during times of turmoil.

In other words, if you want to take full advantage of all the wonderful values in the market today, you need to look into small-cap stocks.

Small is good
At Motley Fool Hidden Gems, we look exclusively at companies capitalized at less than $2 billion, with little or no analyst coverage, that are led by dedicated managers/founders, and that have a wide market opportunity. It's here that you are going to find the companies that truly are undervalued.

So far, that strategy has paid off. Since inception in 2003, Hidden Gems is outperforming the S&P 500 by 20 percentage points.

To see our newest recommendations and top picks for new money now, click here to join Hidden Gems free for 30 days. There is no obligation to subscribe.

Ilan Moscovitz owns shares of Apple, a Motley Fool Stock Advisor recommendation. JPMorgan is an Income Investor selection. The Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (73)

Comments from our Foolish Readers

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 08, 2008, at 1:12 AM, ksag wrote:

    For the large caps, breaking 278 stocks into quintiles gets pretty thin on the numbers. The performance when going from Q5 to Q1 is pretty erratic to say the least. Are you sure, given the std. deviations both within and between quintiles that the differences are significant. Great article, love the analysis between the small caps and large caps. I'm already a Hidden Gems and Advisor member.

  • Report this Comment On August 08, 2008, at 9:11 AM, KWT8011 wrote:

    Interesting information!

  • Report this Comment On August 08, 2008, at 9:31 AM, Schopenhauerfan wrote:

    Is this article some sort of backhanded endorsement of Technical Analysis?

    Certainly seems contrary to even the weak form of the EMH

  • Report this Comment On August 08, 2008, at 2:25 PM, TMFCaccamise wrote:

    Schopenhauerfan,

    I wouldn't call this article a "backhanded endorsement of Technical Analysis". I would call it more of a warning for value investors during this bear market. It basically challenges investors to make sure our long-term investment thesis on any of the myriad of beaten down stocks is correct. Just because a once-loved stock looks cheap doesn't mean that it is. Some companies can come out of a long recession with serious damage.

  • Report this Comment On August 08, 2008, at 4:47 PM, Sand105 wrote:

    This is as foolish (with a small "f") as the Foolish Four.

    You are working on the assumption that the time period you chosen is representative of the market as a whole. Fact is that the bubble you are testing against was perhaps the largest asset bubble ever. Testing off of the downswing of this +6 sigma bubble I would argue simply isn't representative.

    If this relationship holds with the downswings (and subsequent upswings) of 1974, 1982, 1987, 1990, etc. then we can start to pay attention. Until then the veracity of your conclusions simply can't be supported by your evidence.

  • Report this Comment On August 08, 2008, at 4:57 PM, joshbk wrote:

    >over the long haul, small caps >outperform larger companies

    Does that account for companies that went out of busienss?

    Good article otherwise, but stocks that go under are rarely accounted for in long-term market data. So there's a survival bias (especially if you define small cap stocks as any company with net worth between $0 and $1 billion) which isn't present for large caps that rarely go out of business. And the bias is especially pronounced during a recession, which would cause more small caps to go out of business than usual.

  • Report this Comment On August 09, 2008, at 1:29 AM, TMFDiogenes wrote:

    Thanks everyone for these very thoughtful comments.

    "You are working on the assumption that the time period you chosen is representative of the market as a whole... If this relationship holds with the downswings (and subsequent upswings) of 1974, 1982, 1987, 1990, etc. then we can start to pay attention."

    In the article I acknowledge that "recent years have been an exceptionally good time to own small caps." I can't speak to your question about how well the relationship I identified would have held up during every one of the downswings since the 70's since that wasn't the focus of the article (though I agree it would be interesting to look into). But the wider point stands, that over the past 80 years small caps have outperformed large caps by a considerable margin, and I suspect we would see similar results during many of the periods you mention.

    Unfortunately there was no way I could account for survivorship bias in this screen without billing the Fool for an army of graduate students to reconstruct a more comprehensive database of companies that existed at the time but no longer are. It's true that there are a number of smaller companies which, by virtue of going out of business, are unaccounted for in the data I had to work with. However it's important to remember that many of the companies that went under following the tech bubble had enormous market capitalizations: Exciteathome ($40 billion), Exodus ($32 billion), Commerce One ($21 billion), and eToys ($10.3 billion), are just four examples of large-cap bankruptcies between 2001 and 2004. So even if Tom Gardner had made available the $1.2 million research grant I never requested, I believe we would have seen similar results.

    Ilan

  • Report this Comment On August 09, 2008, at 11:48 AM, joshbk wrote:

    Points taken, thanks.

    Just intuitively though, if you're running a business during a recession, it seems like it'd be scarier to run a small (or mom & pop) business than a large business.

    On a separate note, in favor of the argument, one idea might be that a recession offers a shakedown of sorts, or a judgment day. If a business is able to thrive, or just get by, during a bull market (or normal times) then it might just be riding the wave. But if it can thrive during a recession, then it's really worth its salt.

    Like the difference between a quarterback who looks good because he has a good offensive line and skilled wide receivers, versus a clutch player who proves himself in the most difficult of situations. Like they say, people only show who they really are during the most difficult of times. Or a better analogy might be made to evolution by means of natural selection. It takes droughts and periods of starvation for an organism to rise above the mix - it's no coincidence that humans and many of the hardiest animals came out of some of the harshest and unmerciful places on earth.

    To ad a layer to the analysis, it might be interesting to look more within groups, That is, group companies by cap-size, by market trends, and then compare those that thrived vs. those that didn't, during bear, bull, and normal times. I'm not sure what (quantitative variable) to compare them on though, but I'm new to all of this.

  • Report this Comment On August 15, 2008, at 12:35 PM, camainc1 wrote:

    I'm not an investment expert, but it seems like you can take any short time period and measure it against any other short time period, and get wildly differing results.

    Better to stick with index funds and let the market do its thing over the long haul.

  • Report this Comment On August 15, 2008, at 1:24 PM, jlmcconchie wrote:

    Do these statistics reflect total returns? Namely, do they include reinvestment of dividends during the applicable periods? I am a member of the Motley Fool Income Investor program and so am keenly interested in whether small caps outperform large caps not only in terms of capital gains but in terms of total gains.

  • Report this Comment On August 15, 2008, at 3:37 PM, JesterWOCourt wrote:

    Are the small caps in the comparison in the same field as the large caps? I'd wager the large caps that took a beating were probably in the field directly associated with the recession... and if you're comparing large cap tech-bubble stocks to small cap energy stocks there would of course be disparity in the returns. In short, my reaction to the phrase "This time I compared the post-recession returns of the aforementioned 278 large caps to the performance of 1,740 smaller companies." was "where did those small caps come from? What do they have to do with anything related to the content previously provided?

  • Report this Comment On August 15, 2008, at 5:06 PM, TMFDiogenes wrote:

    Hello,

    camainc1,

    I certainly respect your decision to stick with index funds and let the market do its thing. That's a fine strategy -- you'll likely outperform most mutual funds and almost certainly outperform trend followers. However, I don't believe small cap investing to be trend following. It's a strategy that the data shows pays off over the long term. As I mention in the article, Fama and French found that small caps outperformed large caps, basically over the past half century, 17% to 13%. (Their data also showed that small caps significantly outperformed as far back as 1927! http://www.fool.com/investing/small-cap/2006/01/12/70-times-... ) Just something to consider.

    jlmcconchie,

    Those returns don't include any reinvested dividends. I just ran the numbers for you and found that, with dividends reinvested, large caps produced 13.9% returns, small caps 18.5%.

    JestorWOCourt,

    I apologize if that was unclear. I compared the entire body of then small caps trading on major U.S. exchanges ($100M<cap>$2B) with the entire body of then large caps ($10B<cap) trading on major U.S. exchanges.

    Fool On!

    Ilan

  • Report this Comment On August 16, 2008, at 10:03 AM, Scones wrote:

    Great article. The numbers bear out that small-cap value has the strongest returns going back to 1923. I use to chase non-profitbale companies that appeared to be doing well, but it often became a losing proposition. Over a 17 year period if you would've bought companies selling at a 50% discount or more in relation to their respective industry, and with growing earnings, you would have returned 30% plus. This number was using a buy and hold strategy of 1 year. As far as technical indicators are concerned, why not use them? I would much rather enter these companies with indications of a reversal occuring in their share prices than not...Just some things I've discovered through the "school of hard knocks." Happy trading Fools :)

  • Report this Comment On August 17, 2008, at 6:46 PM, BSolom wrote:

    I'm short COF --- My thinking is that if people aren't able to pay their mortgages, then they'll certainly not be able to pay off their maxed-out credit cards --- we'll know if this strategy works in a qtr or two

  • Report this Comment On August 18, 2008, at 8:27 AM, briboe wrote:

    Does the Motley Fool put out any good info? I'll give them an A+ for marketing, an F for everything else.

  • Report this Comment On September 04, 2008, at 4:39 PM, TMFDiogenes wrote:

    A stat regarding small-cap performance during past recessions: According to T. Rowe, they beat large caps by 9% on average in the year coming out of each of the past 10 recessions.

    http://www.newser.com/article/d91micog0/small-caps-historica...

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