Don't Touch These 3 Huge Value Traps

"Valuations are starting to get silly."

That's what the chief investment officer at a major commercial bank said during a recent call on the state of the economy.

With the S&P 500 down 39% 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 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:

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 the present financial disaster illustrates, companies often get punished for all the right reasons. Witness the arguably deserved suffering of regional banks like Colonial Bancshares (NYSE:CNB) and Keycorp (NYSE:KEY), or insurance behemoths Ambac (NYSE:ABK) and AIG (NYSE:AIG). In those cases, their plight can be as bad as you think -- and worse.

The envelope, please
Here are the names of three huge companies (market caps around $10 billion or more) that are very likely 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
• Returning among quintiles whose performance was anemic during the last recessionary go-round
• Rated one or two stars by our CAPS community

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, Yahoo! Finance, and Capital IQ, a division of Standard and Poor's.

Yes, shares of these companies have fallen dramatically, but that's because they've dealt with massive writedowns, deteriorating business units, managerial missteps, share dilution, CEO firings, and/or declining market share 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 does repeat 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 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:

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. Not only did the most beaten-down small caps outperform their spared peers, but every quintile of small caps also 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: buying $58 billion Qwest (NYSE:Q) in November 2001 when it was "on sale" for 66% off. The stock fell another 29% over the next five years. On the other hand, $1.2 billion Millicom International fell by a similar amount during the recession, yet contrarians who bought this underfollowed company made back their money more than five times over.

In fact, every single one of the top 10 stocks since the last recession was a small or mid cap. Among the very largest of those companies destined for greatness were then-$2.9 billion BlackBerry maker Research In Motion and $3 billion fertilizer producer PotashCorp.

Periods leaving recessions are great times to own small caps, and a number of studies have also 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 7 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.

This article was originally published on Aug. 7, 2008. It has been updated.

Ilan Moscovitz doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.