Active Value Investing: Avoiding Value Traps

Key Points

  • The fundamental case for value outperformance in coming years remains strong but a more selective approach may be warranted that seeks to avoid value traps. These value traps, cheap companies whose debilities have not yet been fully reflected in prices, increase risk and erode returns for value investors.

  • Based on a 32-year study of US equity performance, an investment strategy that succeeds in avoiding value traps provides better upside potential through more concentrated yet less risky exposure to the least expensive stocks. Screening out characteristics that signal value traps is a simple way to achieve this.

  • Low quality and sentiment-driven momentum are common features of value traps. By purging problem stocks using momentum and quality signals, returns improve across all but the most expensive companies. These improvements are most notable in the two cheapest valuation quintiles of the market, with the projected value premium increasing by an estimated 5.2% per year.

Que Nguyen is the corresponding author.

"An investor has to do very few things right as long as he or she avoids big mistakes." Warren Buffett, Berkshire Hathaway Inc 1992 Shareholder Letter

After a decade in the wilderness, value investing roared back to life in 2022, led by long-forsaken sectors such as energy, industrials and even certain retailers. Many portfolios had either intentionally or unintentionally migrated heavily towards “growth at any price” exposures and were caught wrong-footed that year. Research conducted in 2020, at the depths of value underperformance, revealed that the contemporaneous preference for growth stocks was not sustainable in the long run Research conducted in 2020 at the depths of value underperformance (Arnott, Harvey, Kalesnik, and Linnainmaa, 2020). The researchers estimated that, even if the relative valuation of value and growth stocks were to remain extreme, the structural components of value should lead to annualized outperformance of 4.5% per year. Should the relative valuation gap revert to a more normal level, the outperformance of value would be even greater.