s 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.
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