Beware these bargains and evade the value traps

We are a nation obsessed with bargains whether its retailers tempting us with Easter sales, or investors looking for the next great discounted opportunity but now more than ever is a time to look out for value traps.

Beware these bargains and evade the value traps

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Europe and emerging makrets are currently touted by equity investors as cheap investments, but putting PE ratios aside, is there really value to be had or are they cheap for a reason? It is hard to tell, though perhaps investors can learn from the classic value trap of old, Japan
 
 “In essence, anything bought cheaply has potential to be a value trap until some kind of catalyst releases that value,” says PSigma Investment Management CIO Tom Becket.
 
“With Japan, the country has often proved a value trap over the years and we had many painful months before Abenomics finally bore fruit in 2013. We felt the country was due for political change that would bring through a new monetary policy and corporate transformation and on that occasion, were happy to be in the market early. Japan has often deceived investors before however and the problem with value traps is that they are typically that way until, suddenly, they are not.”
 
For Becket, emerging markets are another potential trap at present, though he remains confident that they will deliver growth in the long term.  

Things must improve

“China and North Asia are extremely unpopular but we feel an economic transformation is occurring and sentiment is simply so bad that it must improve,” he adds.
 
“Current valuations are compensating investors for the risks and it is hard to deem any market a value trap when there are so few investors trapped in it.”
 
Those with a lower tolerance to risk may prefer to focus instead on ‘quality’ companies; those defined as having low volatility and high profitability characteristics. 
 
However, Paul Ehrlichman of ClearBridge, and manager of the Legg Mason Global Equity Income Fund, this focus is looking increasingly challenged, both cyclically and structurally, and potentially prone to value traps. 
 
He says that as economic conditions continue to normalise, the drivers of earnings growth are likely to change: “We believe that to identify [attractive] investments, it is critical to understand the effectiveness of underlying fundamental factors are subject to change and emphasise the characteristics most likely to be rewarded in the coming cycle.” 

Backtest blindness

“This helps us avoid ‘backtest blindness’ and falling into the trap of favoring characteristics that are cyclically extended. We learned this painful lesson back in the late 1980s when the end of a spectacular 15-year run in value investing rendered the most popular factors less effective for the next decade. Since that time our focus has broadened to include value, growth, profitability, quality and momentum screening tools.”
 
While the idea of buying the most profitable companies in the world at low valuations sounds appealing, this combination actually often identifies value traps, he adds.
 
A more in-depth look at value traps, and how they can be avoided, features in the May edition of Portfolio Adviser, out soon.