Energy and commodity prices reached unprecedented heights only a few short months ago; now their rapid decline has value investors kicking the tires. A new report from Merrill Lynch in the U.S. issues a buyer-beware warning on these sectors, calling them value traps.

Traditionally a term used to refer to individual stocks, “value traps” are investments purchased at historically low prices that stay low, rather than rebound. Merrill Lynch has created a statistical model, called the U.S. Momentum and Value model, that attempts to identify industries that are undervalued and offer good value opportunity, and tries to separate these from the value traps.

In this month’s report, Merrill Lynch says the Energy Equipment and Services and Independent Power Producers and Energy Traders sectors, along with Metals and Mining, are potential value traps according to its statistical model.

The suggestion that cyclical energy and materials sectors are value traps certainly raises some eyebrows. Commodity prices have fallen fast and hard, but in general commodity producers, particularly oil and gas companies, remain well capitalized. The Merrill Lynch report points out that these are exactly the characteristics value traps will tend to exhibit.

“Our U.S. Momentum and Value model identifies industry value traps that appear significantly undervalued relative to their historical averages, but have deteriorating price and estimate trends. The reason they appear inexpensive is because their price decline is outpacing their fundamental deterioration. These industries tend to remain trapped in this category until an external catalyst propels them out,” the report says.

Roughly two-thirds (67%) of those industries Merrill Lynch tagged with the value trap moniker failed to outperform the market in the following month; only 3% managed to achieve an improved price performance and earnings per share (EPS) outlook.

The model does seem to have some flaws, most noticeably the short-term analysis of industries. Most value investors have to wait much longer for a turnaround. As the study points out, an external catalyst can easily shift the fortunes of a sector — arguably, there are few industries that are more susceptible to external catalysts than the resource and materials sectors.

In Canada there are some misgivings about the study from those who actually do stock picking in these sectors. Kim Shannon, president and chief investment officer of Sionna Investment Managers and one of the country’s most recognized value managers, says there is tremendous opportunity in the Canadian energy sector, in particular, with the current slide in valuations.

“I don’t see any value traps in that industry — maybe in the micro-caps. Most of the stocks are fairly priced in the segment,” she says. “Value traps are those stocks that stay cheap forever — that’s what a value trap is. Often, they have excessive levels of financial risk. Cash flows have been fantastic for the large-cap names and the integrated [energy companies]. The stocks are trading in a lot of cases at fair price and are outright cheap in some cases like Petro-Canada. I think there are interesting long-term opportunities in the sector.”

Garey Aitken, chief investment officer of Bissett Asset Management, a subsidiary of Franklin Templeton Investments, says the study is valuable for pointing out that short-term earnings are not a good predictor of a stock’s intrinsic value — especially true in the energy sector, where the spillover cash flow from high oil prices is still trickling down into earnings statements.

“If people were to look at 2008 earnings in particular, with respect to materials and energy, any sort of current valuation work you might do would make that sector look awfully attractive — certainly more attractive than it currently is,” he says. “You don’t want to base your decision making on a snapshot in time [with] earnings that might not be sustainable.”

For example, Aitken says, the Q3 earnings statements, which are now being released from oil producers, include revenue numbers generated when a barrel of crude oil was priced at $145 in July. Given the recent slide in oil prices, those earnings are not realistic when it comes to determining future valuations — which is why stock prices tend to be more discounted than earnings data would suggest.

Aitken says prudent investing in cyclical sectors like energy and materials requires a long-term view to determine what is undervalued.

“I’m a very strong believer when you get into cyclical industries like commodity-driven industries that valuation work should best be done at prices on a normalized basis or a trend basis that is based on a long-term view,” he says.

Aitken says the merits of the Merrill Lynch study are slightly undermined by the fact that catalysts play such a big role in determining valuations. For the most part, they are extremely difficult to anticipate.

“Sometimes when people talk about value traps, they’ll also be suggesting or implying there is no identifiable near-term catalyst that will change the fortunes of the stock price,” he says. “I’m kind of leery of that kind of thinking. I think quite often security prices can recover, and they can fall further; it’s usually based on an event we didn’t anticipate at any particular point in time. There are always unknowns. I don’t think it’s easy to try and identify whether catalysts exist or not.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(11/10/08)