Don't Touch These 3 Huge Value Traps

With the S&P 500 still down some 25% 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:

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 financial disasters at WaMu, Capital One (NYSE: COF), 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.

Net charge-offs continue to rise at Capital One -- the company has to set aside $0.46 in losses for every dollar in interest income. Royal Bank of Scotland remains on government life support after billions of pounds in losses; its former top investment banker recently conceded to regulators that he would never hold a significant position in the industry again. American politicians have repeatedly insisted that their half-hearted regulatory reforms aren't meant to punish Wall Street. But apparently in England, which doesn't have paid political advertising, they actually do punish the people and institutions that played a role in annihilating the global economy.

The envelope, please
Here are the names of three huge companies that are likely to be value traps. All three have had massive declines, which make their 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 rankings, by our Motley Fool CAPS community.

Data from Motley Fool CAPS 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 only because they've dealt with massive writedowns, 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 massive companies generate on Wall Street (as illustrated by the final 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. Instead, 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 of the gap astounded me:

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

A small-cap contrarian approach following the previous 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 previous 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 $18 billion Tellabs back in November 2001, when it was "on sale" for 70% off, because it's nowhere near recovered. But $274 million Titanium Metals, which had fallen by a similar amount, went on to become a 37-bagger.

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 PotashCorp (NYSE: POT). These were, and they remain, two companies with rapid growth, high margins, and significant competitive strengths from their brands and lead development times, respectively. Of course, their success has attracted more attention since then.

Studies have shown that over the long haul, small caps outperform larger companies. According to research from professors Eugene Fama and Kenneth 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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So far, that strategy has paid off. Since the service's inception in 2003, Hidden Gems picks are outperforming the S&P 500 by a wide margin.

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

Ilan Moscovitz doesn't have a stake in any company mentioned. Sprint is an Inside Value selection. Titanium Metals is a Motley Fool Stock Advisor selection. The Fool has a disclosure policy.