The energy sector’s valuation compression was based on the surprising weakness in oil prices, which are a key determinate of energy company revenue and profitability. Front-month West Texas Intermediate crude oil futures were priced at over $100 per barrel in June 2014 and had plunged to less than $35 per barrel by March 2016. The increased use of fracking — a disruptive technology change — played a key role in the energy sector’s value trap. Even though fracking was not a new concept in 2014, its impact on production, coupled with an ongoing economic slowdown, contributed to valuation compression within the energy sector.
Overcoming value traps
One way to overcome value traps may be to combine the value and momentum factors. This is because the value factor can screen for stocks that are attractively priced, while the momentum factor looks for stocks that have recently demonstrated strong risk-adjusted returns, which may help reduce the probability of buying into a value trap. Rising value stocks may be a sign that value is being unleashed and a stock is moving toward its intrinsic value.
Of course, there is always the risk that momentum stocks fall out of favor as market conditions shift. Companies can report bearish business developments that can reverse a positive price trend and catch investors leaning the wrong direction. Moreover, the momentum factor can struggle during periods where investors are reducing risk and asset returns are highly correlated.
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The momentum factor may also provide an opportunity to manage risk. This is because value stocks showing poor momentum can be removed from a portfolio (depending on when it reconstitutes), reducing the chances of continuing to hold a value trap.
Investors interested in the combination of value and momentum may wish to consider the PowerShares S&P 500 Value With Momentum Portfolio (SPVM), which combines the momentum and value factors and is rebalanced and reconstituted semiannually.
This article has been republished with permission from Invesco Powershares.