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Tuesday, March 3, 2009

"The Value Trap"

I mentioned in my Jan 30 post that quantittive screens to identify value stocks based on measures of book to market suffered s they identified mny financial stocks as ttractive. A recent WSJ article explores this problem s a mjor factor in the poor performance as of late of value vs growth (the chart above left shows the underperformance of large growth vs lrge value)

Even the 'Value' Investors Can't Beat This Bear
Steve Dininno
This downturn, however, has been especially cruel to "value" investors, those who search for companies they believe are priced lower than they should be.
The concept of value investing was invented around the time of that 1929-32 bear market by Columbia University professor Benjamin Graham. The current patron saint is Warren Buffett, widely considered one of the wisest men in finance.

But Mr. Buffett's investment vehicle, Berkshire Hathaway, is down 43% in the past year. Other famous value investors, such as Bill Miller of Legg Mason funds, have taken unprecedented poundings.

To be sure, there have been few safe harbors for stock-market investors of any stripe in this downturn. But value stocks have been the unsafest of all. Since the market peak in October 2007, an iShares exchange-traded fund designed to mimic value stocks in the S&P 500 is down some 56%, compared with 53% for the S&P 500 itself. The iShares ETF that mimics "growth" stocks -- those with fast earnings or price growth -- is down about 44%.

Recessions Are Tough on 'Value'
Contrary to popular belief, value strategies often do poorly during recessions, especially relative to growth strategies.
The reason is simple: When growth is scarce, as it is in a recession, then investors pay a premium for companies that manage to keep growing. One memorable exception was the recession of 2001, when investors dumped growth companies -- mostly overpriced technology stocks -- as if they were toxic.
"It's not unusual for value to suffer in a recession," says Joseph Mezrich, head of quantitative research at Nomura Securities International. "What's unusual this time is the magnitude" of the suffering. In this recession, the value-stock barrel has been spoiled mainly by a bunch of very bad apples: banks.

Value investors often hunt for companies that have a low ratio of stock price to "book value," which is roughly the value of their assets minus their liabilities. For various reasons, banks typically have very low price-to-book ratios, so they often turn up on the radar screens of value investors.
When the banks started taking heavy losses in late 2007 on mortgage bets gone bad, their share prices fell, which made their price-to-book ratios even lower, making them even more irresistible to value investors.
The trouble was the "book" part of that ratio: Trillions of dollars of the assets on bank balance sheets were tied up in mortgage debt, which was rapidly declining in value. That made book value a target that was moving fast in the wrong direction: down.
Misreading the Downturn
And that meant the stocks weren't nearly the bargains they seemed and just kept falling -- a phenomenon some analysts call a "value trap."
"A lot of people were buying these stocks all the way down," says Bill King, chief market strategist at M. Ramsey King Securities. "Their models couldn't pick up what was garbage, so they couldn't adjust quickly enough."

Numerous false springs, usually triggered by government bailouts and interventions, have lured more investors into the value trap. Financial stocks have rallied briefly several times, only to later fall to fresh new lows. And the more their stock prices fall, the easier it becomes for them to generate eye-popping rallies that may overstate their true strength.

Meaningless Bounces
For example, a 50-cent increase in Citigroup's share price in October 2007, when it was about $44, would have been a healthy but unspectacular 1% gain. A 50-cent increase in Citi's $2.50 share price -- as happened on Feb. 24 -- would be a 20% gain. That's a bull market, by some definitions, but isn't really meaningful, given the uncertainty surrounding Citi's future. (The stock closed at $1.50 Friday.)
Most value investors in the Graham/Buffett mold care little about the short term and hope to pick up bargains that will pay off in the long run.

But buying financials likely won't start to pay off until all the toxic assets are cleared off their balance sheets, they start lending again and the recession ends. If you buy financials today, you will likely have to be willing and able to wait until the end of 2009, at least, to see that happen.
Other value stocks -- including home builders and other companies tied to consumer spending -- will also likely have to wait before they start to rise again, as their survival also depends on a growing economy.

Interestingly, Two of the premier academic exponents of value investing Eugene Fama of the University of Chicago and Kenneth French of Dartmouth University retain what I view as the “value trap” view of the financial sector:

DEC 11, 2008
Q & A
Q&A: Book Value
What is the validity of book value in today's environment, especially as it applies to financial firms?
There is always an issue about how to "properly" measure value. But all the work we have done says that at least for diversified portfolios, it doesn't much matter.
Alternative price ratios, like earnings/price and cashflow/price, work about as well as book/price, in terms of identifying value stocks and growth stocks. Every ratio has its problems because whatever fundamental one puts in the numerator has its own accounting issues. As a result, there are inevitable misclassifications of stocks, but they should wash out in diversified portfolios like ours.
We don't see any special problems with the book/price ratios of financial companies. —EFF/KRF
(the chart at the right top is the etf for financial services (iyf))

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