Don't Touch These 3 Huge Value Trapshttp://www.fool.com/investing/small-cap/2008/09/10/dont-touch-these-3-huge-value-traps.aspx Ilan Moscovitz
September 10, 2008
"Valuations are starting to get silly."
The chief investment officer at a major commercial bank spoke these words during a recent call on the state of the economy.
With the S&P 500 down nearly 15% year to date, shares of even stable blue chips cratering, and investors scared witless, others are wondering whether it's time to take advantage of some great bargains.
So the urgent question is: Does buying beaten-down stocks automatically lead to riches?
The shocking truth
Here's what I found:
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?
The savviest investors know that willy-nilly contrarianism isn't a sure path to riches. As financial disasters at First Horizon (NYSE: FHN ) , Corus Bancshares (NYSE: CORS ) , and JPMorgan Chase's 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
Since we began tracking the collective intelligence of our CAPS investment community in November 2006, one- and two-star companies have fared poorly, with an average annualized loss of 11.4% and 5%, respectively.
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 writedowns, 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 repeats itself, thrashed large caps won't 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 approach to contrarian investing
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.
And that last recession was no anomaly; according to T. Rowe Price, small caps have beaten large caps by nine percentage points on average over each of the past 10 recessions.
Among the most disappointing contrarian plays would have been buying $65 billion Sun Microsystems (Nasdaq: JAVA ) in November 2001, when it was "on sale" for 46% off -- because the stock still had another 51% to fall over the next five years. On the other hand, $1.5 billion SanDisk (Nasdaq: SNDK ) fell by a similar amount during the recession, yet contrarians who bought this underfollowed company made back their money more th