How to Avoid Value Traps

Investors like the value factor and the idea of stocks that look like good deals, but the value factor is not always as pure as it may seem. In fact, many stocks that on the surface look like value plays are actually dreaded value traps.

The PowerShares S&P 500 Value With Momentum Portfolio (BATS: SPVM), which debuted last month, can help investors dodge stocks that are value traps. SPVM follows the S&P 500 High Momentum Value Index, which “tracks the performance of stocks in the S&P 500 Index that have the highest value and momentum score. Constituents are selected through a two-step process: first, the 200 stocks with the highest value scores; second, 100 securities with the highest positive momentum scores,” according to PowerShares.

Value stocks usually trade at lower prices relative to fundamental measures of value, like earnings and the book value of assets. On the other hand, growth-oriented stocks tend to run at higher valuations since investors expect the rapid growth in those company measures, but more are growing wary of high valuations, especially as the U.S. equities market moves toward the ninth year of an extended bull run.

“While value can be an appealing investment strategy, identifying value opportunities is not as easy as it might appear,” said PowerShares in a recent note. “One of the drawbacks of value investing is the so-called “value trap.” A value trap occurs when a stock appears cheap, but is trading at low multiples due to underlying problems with the stock’s issuer. In other words, the stock is cheap for a reason and could trade even lower in the future. Changing industry conditions, secular shifts in technology, and management miscalculations can lead to value traps. Further, some valuation measures may be backward-looking when the market is pricing the future.”