“Value stocks” look particularly attractive right now, but simply buying the cheapest ones isn’t the best idea. That’s a sure way to get stuck in a “value trap.”
Value stocks are those that look most likely to be significantly underpriced. They’re often companies that are more mature in their life cycles and have seen the fastest growth they’re likely going to see. Sometimes, that’s because the business is no longer in its infancy and has already become fairly large. Sometimes, it’s because a business has faced strong competition. Sometimes, there’s just not a lot of growth to be had. Either way, there’s a hard ceiling on the price investors are willing to pay to own these firms.
Such low valuations are fairly pronounced today. The
S&P Small Cap 600,
with a majority of its market value comprised of companies in the relatively mature sectors of financials, real-estate, manufacturing, commodities and consumer, trades at about 14 times earnings estimates for the coming year. That’s less than half of the almost 36 times for the
Russell 2000 Growth Index,
which is home to higher-growth companies.
While that’s not quite the absolute largest discount in history, the S&P 600 has traded at well over half the growth index’s multiple in the past 20 years, according to FactSet. That happens when value is more in favor with investors, specifically when economic growth is improving and interest rates are rising, an environment that often coincides with rising profits.
The cheapness doesn’t mean that blindly going all in on value stocks is a great strategy. The key is to buy cheap stocks, but to avoid the absolute cheapest names, which often turn out to be poor bets. Annualized returns for stocks in the bottom quintile of valuations were up 8.9% from 1990 to 2022, according to Research Affiliates data. Stocks at the lower end of the market’s valuation range, but not in the bottom most quintile have seen just over 10% annualized gains.
The reason is that the stocks that are dirt cheap often deserve those valuations.
“The cheapest quintile holds companies so structurally challenged that they either remain severely underpriced, or worse, go out of business,” wrote analysts at Research Affiliates. These companies, which we call value traps, are often described as “cheap for a reason.“
That’s why we screened for the right cheap stocks to look at. We looked for stocks that have forward price/earnings ratios that are in the bottom two quintiles of ratios in the S&P 600. The idea is to avoid the 120 lowest P/E stocks, but to consider names within the second lowest quintile—the 120 names on the screen that have slightly higher P/E ratios. Those are still cheap, but are less likely to have such overwhelming business headwinds that they can never get out from under the challenges.
The stocks to focus on in the screen, which are in the second lowest quintile of earnings multiples, showed a handful financial firms that investors worry will see weakening balance sheets related to the Silicon Valley Bank collapse. There were also many consumer companies that have struggled to keep pace with larger, more successful brands.
Some of the banks are
First Hawaiian,
Northwest Bancshares,
and
Capitol Federal Financial,
which all trade at around 12 times earnings.
Some consumer names are recent Barron’s stock pick Bloomin’ Brands,
Brinker International,
Jack in the Box,
Winnebago Industries,
Kohl’s,
and
Hanesbrands.
It’s these stocks that may be worth a look.
Write to Jacob Sonenshine at [email protected]
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