Good versus Bad Value Stocks

Trying to avoid value traps

March 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Value stocks can be easily filtered by applying quality metrics in order to sort out value traps
  • Value & High Quality generated higher returns than Value in Europe and Japan, but not in the US
  • However, from a risk perspective, metrics improved across all markets

INTRODUCTION

Running a marathon is similar to being a Value investor, especially in recent years where it seems more like an ultra-marathon. Both activities are painful experiences that require the ability to suffer and persist through physically and emotionally straining times. And there is the fear of being attacked by mountain lions or unleashed dogs. The former is only relevant when running in certain US states like Utah, but the latter a global problem, especially in emerging markets.

In the value investing world, there are no mountain lions, but there are value dogs, which are stocks that are cheap and stay cheap. When a novice value investor stumbles across these, they seem like incredible bargains. A price-to-earnings ratio below 10, what is not to like?

However, after years of holding such stocks without much performance to show for, the realization sets in that these are structurally impaired businesses. The stock is not mispriced and market expectations are not wrong, it is simply a dying business. Another name for these stocks is value traps.

Investors have several tools at hand to avoid these siren stocks and one common approach is to rank cheap stocks by another metric, effectively creating a multi-factor portfolio. Ideally, these other factors feature low or negative correlations to Value, where Momentum and Quality represent the most popular choices.

In this short research note, we will contrast Value & High Quality versus Value & Low Quality across stock markets (read Value+Quality or High Quality Value Stocks).

GOOD VERSUS BAD VALUE STOCKS

We focus on all stocks in the US, Europe, and Japan with a market capitalization larger than $1 billion. We utilize a sequential model to first rank all stocks by an equal-weight combination of price-to-book and price-to-earnings multiples and the