Is that cheap stock you have your eye on really a "value trap"?
After a 9.3% drop in the Standard & Poor's 500-stock index this month, most stocks are looking cheap—but some seeming bargains may have more room to fall. Investors need to do more than simply look at price history and buy the most beaten-down stocks, say strategists.
The temptation to load up on such stocks is surely there. Using 12-month earnings forecasts, the S&P 500's average price/earnings ratio is now about 9.9, down from 13.2 at the beginning of the year, according to S&P. And the median stock among the 1,800 tracked by Morningstar Inc. is trading at about 85% of fair value, as measured by the investment-research firm—the lowest percentage since April 2009.
Yet in today's volatile market environment it isn't clear whether a stock is truly cheap or if earnings estimates haven't caught up to falling share prices. That is because analysts cut their earnings estimates more slowly in selloffs than prices fall, meaning the "earnings" in a price/earnings ratio may be seriously inflated.
Now that analysts have started cutting their estimates to account for slower economic growth, investors should assume that many P/Es actually will be higher in a month or two than they are now.
"They're only cheap because their prices are falling faster than their earnings are deteriorating," says Savita Subramanian, head of quantitative strategy at Bank of America Merrill Lynch. "It's too early to buy many segments of the market."
So how do investors spot a value trap? Ms. Subramanian identifies two characteristics: The stock has dropped more than the average stock in the S&P 500 during the past three months, and its earnings estimates are being revised downward faster than its peers. Among industries, capital-market firms and semiconductor companies look to be among the most susceptible to value traps, she says.
Consider money manager Janus Capital Group Inc., which Merrill Lynch cites as a potential value trap. It has a P/E of just 6.7, well below its five-year average of 16.9, and has dropped 33.5% during the past month, compared with 11.1% for the S&P 500. Analysts also have been cutting estimates since the end of April, with earnings per share cut by about eight cents, according to FactSet Research Systems.
Health insurer Humana Inc., by contrast, may actually be a value at current prices. Its P/E is currently 9.3, well below its five-year average of 12. The stock, however, has dropped 13.8% during the past month, less than the S&P 500's 16.5% loss, while analysts have boosted profit estimates more than 9% in August, according to FactSet.
Another way to determine whether a stock may not be as cheap as it looks: Look at analysts' expectations of a company's profit margins and compare them to historical margins, says Adam Parker, head of U.S. equity strategy at Morgan Stanley. If expectations are significantly higher than historical levels, it could be a sign that a company is poised to disappoint.
"If margins are usually 30% and expectations are for 50%, we get concerned," Mr. Parker says. He says health-care stocks have the most compelling estimates, while expectations for industrials and consumer-discretionary stocks look inflated.
For example, Becton Dickinson & Co. is expected to generate operating profit of $1.8 billion in 2011 on sales of $7.8 billion, for a net margin of 22.8%, only slightly higher than the five-year average of 21.4%. Robert McIver, co-portfolio manager of the Jensen Portfolio mutual fund, which owns the stock, likes that stability. "The value of the actual business hasn't changed to the extent the stock price has," he says.
Investors looking to place a high-risk bet on a market bounce should buy the cheapest "cyclical" stocks possible, says Vadim Zlotnikov, chief market strategist at AllianceBernstein, since such stocks should rebound more when the selling finally stops. That means focusing on industrials, energy and telecommunications companies, and financial companies, among others—especially those that have been among the worst 10% of decliners this month and have low price/book or price/sales ratios.
Among this group, says Mr. Zlotnikov: AK Steel Holding Corp., which dropped 38.3% through Aug. 8 and has a price/sales ratio of 0.1, below its five-year average of 0.4 and the industry average of 0.6, and Dolby Laboratories Inc., which dropped 30.8% and has a price/book ratio of 2.1, below its five-year average of 4.7. If the market rebounds, these types of stocks should outperform during the next three months, he says.
"Sure, it's scary," Mr. Zlotnikov says. "But you get paid for the risk with these types of stocks."
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