"Value investing is perhaps the most popular and enduring style of investing," is the finding of a recent American academic study.
Even though they practice what is arguably the most fashionable style of investing, many value investors still call themselves contrarians. That's because they claim to counter the market by looking for stocks that they consider the market has undervalued. But considering the pervasiveness of value investing, especially among professional investors, perhaps it is value investors that are setting the value of the underappreciated stocks. If the market says that the Canadiens hockey player P.K. Subban is only worth $5.75-million, then he is only worth $5.75-million.
Value investors look for stocks that they think are trading for less than their intrinsic worth as calculated by fundamental analysis of book value and price-to-earnings ratios.
Value has been a successful strategy in many markets, but number crunching isn't enough. There has to be some qualitative thinking to go along with the quantitative. Otherwise investors run the risk of falling into a value trap.
A stock might have been trading at a low price-to-earnings ratio, or below book value, for an extended period of time and look inexpensive. But sometimes they are cheap for a reason and that's when the trap springs. The stock could be facing obstacles that can never be surmounted, like a sector that can't recover because of technology advances, or overwhelming competition, or environmental factors.
This is an appropriate time to be thinking about value traps. The debate over two stocks most in the news recently, Apple and Research In Motion, centres around whether or not they are value stocks.
Apple has declined from its recent highs and investors are asking if it is now a value stock based on its recent price history. But what if the competition from Samsung and Google and Microsoft has nullified Apple's market and pricing advantage?
Maybe Research In Motion has bumped up recently because of the introduction of a new product. Or maybe it is because of the speculation of a takeover that might never happen. Is RIM a trap or a good value play?
As the markets recover, investors seem to be starting to accept more risk at the expense of safety and are looking for undervalued stocks that have been left behind. They can avoid traps by recognizing the three types of risks to true value – operational, cyclical and financial.
Operational risk refers to a company's ability remain competitive and relevant in an ever changing marketplace with strategic issues such as shifts in technology or aggressive competition. Cyclical risk refers a company's ability to address economic cycles. Financial risk is the company's ability to access capital on a timely basis and at an appropriate price.
The Canadian insurance companies were hit hard by the 2008 recession. They offered certain investment products with guaranteed returns based on certain assumptions about the stock and bond markets. When both the stock market and interest rates fell, they were left with huge potential liabilities. The stock prices for insurance companies fell and they became the mainstay for many value portfolios. Value investors like them because of the price-to-earnings ratios and their healthy balance sheets. But can the insurance companies sustain if a low interest rate environment continues?
READERS: Worried you're in a value trap? Discuss your fears in the comments.
Edward Trapunski is the author of The Secrets of Investing In Technology Stocks which reached # 1 on the Financial Post business book best-seller list. He was recently the manager of investment communications for a major bank-owned money manager. He is a former managing editor of Stockhouse.ca and StockHouse.com, and editor of Silicon Valley North.