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Beware Value Traps When ‘Everything’ is Cheap

Tuesday, 27 Jul 2010 | 2:36 PM ET

Every industry in the S&P 500 looks like a value relative to the historical average of its forward price-earnings ratio, according to Bank of America Merrill Lynch. Either the profit and economic outlook for each and every sector is totally misunderstood or some of these stocks are value traps.

“While valuations are encouraging, we saw an eerily similar scenario back in early ‘08 – every sector except Utilities was trading at a deep discount starting in early ‘08 – but for the wrong reasons,” wrote Savita Subramanian, quantitative strategist at the firm. “The number of candidates in our value trap model tripled during that year, and the S&P 500 appeared to be inexpensive solely because prices were falling faster than earnings were deteriorating.”

The S&P 500 is up more than 8 percent this month in part because 2nd quarter earnings results have convinced value investors to step in and buy, regardless of the uncertain economic outlook. Just about every upgrade from analysts these days cites ‘valuation’ as the main reason or mentions it as part of the bull case.

The so-called value trap is the bane of the value investors’ existence. Even the best of them have succumbed to this market mirage at least once in their career. Bill Miller, legendary manager of the Legg Mason Value Trust, outperformed the S&P 500 for 15 straight years, but took a crushing blow in 2008 because of his exposure to financials during the credit crisis.

In that case, those stocks were cheap for a reason. Prices were falling in anticipation of an earnings crash that had yet to reveal itself. Miller is confident that is not the case this time around.

“U.S. large capitalization stocks represent a once in a lifetime opportunity in my opinion to buy the best quality companies in the world at bargain prices,” wrote Miller in his quarterly commentary to investors last week. “Exxon Mobil is the largest company in the U.S. equity market, and one of the highest quality companies in the world, yet no one seems to care.”

Bank of America’s Subramanian tries to quantify the difference between true values and value traps by identifying industries “that are selling at discounts to their historical market multiples, but do not yet appear to have any suggestion of an upturn in price performance.” The strategist is searching for companies that appear cheap but their earnings outlook is increasingly looking more negative.

Among the industries popping up as value traps on his screen are software, food staples and specialty retail.

In a rarity these days for individual company analysts, Bernstein’s Colin McGranahan reiterated his neutral stance on Best Buy because its “demand outlook is uncertain and decelerating.”

“While quite cheap versus history and versus retail, this feels much more like a potential value trap than an undiscovered value opportunity to us, and we remain sidelined,” wrote the analyst, who rates Best Buy ‘market perform’.

For the best market insight, catch 'Fast Money' each night at 5pm ET, and the ‘Halftime Report’ each afternoon at 12:30 ET on CNBC.

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