With stock prices getting beaten down, there must be a lot of bargains out there now, right? Maybe not. Some advisors, such as Merrill Lynch, caution investors to avoid declining stocks which may be perceived as good value but aren’t likely to rise even after the financial crisis is over. By using a statistical model that analyzes pricing and momentum, the investment bank is able to separate good value opportunities from value traps.
A ‘value trap’ stock is one that trades at low multiples of earnings, cash flow or book value – but for a good reason: the company’s future is cloudy at best. What may appear like a bargain may never rise in price due to poor management, a lack of solid investor relations or an inability to differentiate itself from competitors.
Merrill’s recent report includes the following industries identified as value traps:
o Electronic equipment & instruments
o Energy equipment & services
o Independent power producers & energy traders
o Industrial conglomerates
o insurance machinery
o Metals & mining
o Personal products
Stocks and funds in these categories are more likely to be down due to their weak underlying fundamentals, not necessarily due to the current economic crisis. Many asset management companies such as Fidelity, Black Rock, and Invesco AIM offer sector mutual funds, which allocate investors’ money to particular sectors of economy. With Merrill’s list, you know which ones you should avoid for the next year or so. Those industries will need a catalyst to propel them into popularity, such as increase in demand on products or services, an industry reorganization or a change in management. Without a catalyst they are dead.
Although there may be some attractive names within the industries on Merrill’s list, the economic environment may also limit short-term gains. Despite US moves to loosen credit, some sectors will likely see further decline in the coming months.
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