Santoli: 2016 is the year of the value trap

Published Sun, Jul 31 20169:59 PM EDTUpdated Mon, Aug 1 20162:17 PM EDT

The market has imposed a high cost on the owners of "cheap" stocks this year. Buying the shares that look least expensive based on a company's reported or projected earnings over a 12-month span has been a ticket to a value trap for a while now. The route followed by Ford last week drove this point home. The stock, already trading beneath seven times expected 2016 profits – less than half the broad market's valuation – fell more than 8 percent after reporting moderately disappointing results. In fact, the 10 cheapest-looking stocks in the Standard & Poor's 500 at the start of 2016 based on forecast earnings were down an average of 9.5 percent this year as of Friday, compared to a gain of more than 6 percent for the S & P itself. That list, aside from Ford, would have included General Motors ; the airlines American and Delta ; biotech giant Gilead Sciences ; and Eastman Chemical . The list also included a couple of winners, such as power producer AES and retailer GameStop , but not nearly enough to compensate for the losers. And this is not just a matter of Wall Street analysts whiffing badly on those profit estimates: Buying the 10 cheapest names based on the prior year's reported results would also have hurt, with that basket down 4.9 percent. According to the market strategists at BMO Capital Markets, focusing on the very cheapest stocks has been among the most unsuccessful of the several-dozen investment factor strategies it tracks. A portfolio of the 25 lowest forward P/E stocks – the "cheapest" 5 percent of the S & P 500 – would have shed more than 14 percent of its value in the past 12 months. This is in contrast to the long-term performance of such a bargain-hunting strategy, which has nicely outperformed the market stretching back decades. There are a few things going on here. First is one of those lessons that investors need to re-learn in every market cycle: Cyclical stocks with very low P/E's can at times be the most dangerous, because the market is implicitly saying that those earnings have peaked or soon will, making this cheapness illusory. This seems to be the case lately with the auto cycle, as shown by the cosmetic cheapness of GM and Ford. Other names on the lowest-P/E list include Bed Bath & Beyond , a leading retailer with still-strong cash flow but shadowed by daunting concern over the long-term threat of digital commerce. Then there's Gilead, an accomplished drug developer with a stupendously effective liver drug, which the market sees as a finite profit bounty that will be hard to replace. The obverse of this: The time to buy cyclical stocks is often when they have high P/E's even after they've have been beaten down. The recent strong bounces in the likes of Advanced Micro Devices , US Steel and Cliffs Natural Resources – in sectors that already had steep profit retrenchments - illustrate this pattern, as the market tries to sniff out the rebound from trough profit. Those cheap auto and airline names might fare better once profit forecasts are cut and the market gains fresh confidence in them. The hazard of buying cheap stocks is heightened, perhaps, in a market like this one where the profit cycle is quite mature, profit margins have retreated from high levels and the danger has risen that some industries will hit the earnings downslope imminently. Last year saw a dramatically uneven market profile in response to an extreme scarcity of demand growth and profit expansion in the world. Those select handful of companies with powerful organic growth – exemplified by the so-called FANG foursome of tech leaders – surged in value almost to the exclusion of the rest of the field. While the 2016 stock advance has been far more inclusive – especially among stocks with decent and reliable dividends – the spread between the highest and lowest valuations remains quite extreme. The latest quarterly investor letter from Pzena Investment Management, a value-investing firm that has been caught on the wrong side of this trend, notes that the gap in core valuation between the most- and least-expensive 20 percent of all U.S. stocks has only been higher in the myopic, manic tech-stock bubble of 1998-'99. Assuming this relationship reverts toward the long-term norm – and this could be a risky assumption – implies huge relative outperformance by currently cheap equities over the next three to five years. Of course, plenty of investment pros came into this year heralding a rotation into value from growth stocks. Speaking favorably of "value" always sounds sensible and contrarian, but these cycles don't follow a preset script or schedule, so patience and an ability to live with seeming "wrong" for a while is necessary. Investment blog The Brooklyn Investor highlights the apparent value opportunity now and cites the Gotham Funds run by value guru Joel Greenblatt's firm as a fine play on it, mechanically buying the cheapest and selling or shorting the dearest names. These funds include Gotham Absolute Return , which has just perked up after a run of lagging results. As the Pzena managers say, "This is not to suggest that precise timing strategies are readily available: the findings do not apply to shorter time frames, and even when we restrict attention to 3- and 5-year horizons, history is not without its painful exceptions, including the very recent period." Coming out of the 2011 market correction, value seemed positioned to put up some excellent numbers, and hasn't. Are the value indexes too full of financial stocks and structurally vulnerable Old Economy companies? Is the current preference for low-volatility bond-like stocks with predictable cash flows set to continue as yields sit near zero, sapping interest in companies with lumpier results? Are we in the midst of a 1998-style liquidity-driven bull-market overshoot, as suggested here in recent weeks? Is the apparent cheapness of various industrial and consumer cyclicals foretelling the end of the economic expansion before those three- to five-year reversion tendencies can do their thing in favor of cheap stocks? Foreboding, high stakes questions like these always surround long-running anomalies in the market, whether the patterns are set to reverse or not. There is no comfortable way out of the value trap. Liberation has always, eventually, come - but often only after most investors abandon hope.

Traders work on the floor of the New York Stock Exchange.

Michael Nagle | Bloomberg | Getty Images

The market has imposed a high cost on the owners of "cheap" stocks this year.

Buying the shares that look least expensive based on a company's reported or projected earnings over a 12-month span has been a ticket to a value trap for a while now.

The route followed by Ford last week drove this point home. The stock, already trading beneath seven times expected 2016 profits – less than half the broad market's valuation – fell more than 8 percent after reporting moderately disappointing results.

In fact, the 10 cheapest-looking stocks in the at the start of 2016 based on forecast earnings were down an average of 9.5 percent this year as of Friday, compared to a gain of more than 6 percent for the S&P itself. That list, aside from Ford, would have included General Motors; the airlines American and Delta; biotech giant Gilead Sciences; and Eastman Chemical. The list also included a couple of winners, such as power producer AES and retailer GameStop, but not nearly enough to compensate for the losers.