Don't Touch These 3 Huge Value Traps

"Valuations are starting to get silly."

So said the chief investment officer at a major commercial bank during a recent call on the state of the economy. With the S&P 500 still down more than 30% in since its 2007 high, some folks are wondering whether it's time to take advantage of incredible 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 it was overvalued to begin with.

The savviest investors know that willy-nilly contrarianism isn't a sure path to riches. As recent financial disasters at WaMu, First Horizon (NYSE:FHN), and Royal Bank of Scotland (NYSE:RBS) 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 companies that are very likely to be 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 companies.
• Among quintiles whose performance was anemic in the last recessionary go-round.
• Rated with one or two stars (the lowest ratings possible) in our Motley Fool CAPS community.

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

Yes, shares of these companies have fallen dramatically, but that's because they've dealt with massive writedowns, deteriorating business units, managerial missteps, and/or serious deleveraging in the face of an already ugly economic period.

Given the amount of attention these massive companies generate on Wall Street, there's a strong chance that the sell-off was justified. If history is to 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 looking.

A contrarian contrarian strategy
This time, I compared the post-recession returns of the aforementioned 278 large caps to the performance of all 1,740 small caps. I had expected some disparity in their five-year returns, but the 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 also, 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 than eight 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 (NASDAQ:RIMM) and $3 billion fertilizer producer Potash Corp (NYSE:POT).

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 13.6% to 10.9% on average from 1927 to 2008.

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

Ilan Moscovitz doesn’t own shares of any companies mentioned. The Fool has a disclosure policy.