There is one sector that keeps popping up on my screener during my search for value in these US markets: Retail. A quick Google search for “Retail Stocks Down” in the news section returns 1,290,000 results in 0.61 seconds. Quite impressive. Everyone and their mothers are telling each other to sell retail stocks. There are so many options to choose from to see the demise of the Retail Sector. In future articles, I will reveal a couple of companies I have highlighted as potential candidates for active investment. However, one of the problems when an entire industry is in decline is the chance of value traps.
Value Traps are a common mistake in value investing communities, and if one doesn’t tread carefully, they can fall into these traps and lose tremendous amounts of money. The main reason why these value traps become so devastating to one’s capital isn’t really financial at all, it is mainly psychological. Why? When taking a value investing approach, and even more so, a deep value contrarian approach, is that the investor can fall into the thought pattern of, “Well now that the price has dropped, I should buy more because that’s what value investing is all about!” This is dangerous thinking, and the thinking is driven by metrics and valuations. This is where the second part of the Value Trap comes in.
If you poll a random set of those in the investing community, and you were to ask those people what they think it means to be a value investor, what would the responses be? Many would reply by saying to, “Invest in low price to book, low price to earnings, avoid debt, and find companies that are trading at a discount to fair value”, etc. These are all good, nice qualities to look for in companies, but if an entire industry is going down, some of these numbers will be skewed. For instance, let’s take a look at price to earnings. If a companies share price is falling fast, and the industry is in recession, the price to earnings ratio is going to be low because of the downfall of the industry.
Price to Earnings ratio is the perfect example of what can happen when investors fall victim to merely looking at ratios and buying the lowest PE ratio stock. They don’t take into consideration the relativity of the industry mean PE ratio. Another example would be the oil industry. A few months ago, I did an analysis on Valero Energy Corp in which I expressed my hypothesis of a turnaround within the oil industry spurred by a rise in oil commodity prices. Around September 30th I expressed a bullish hypothesis for VLO, with a share price around $53.00. Since then, VLO climbed higher and higher, and now it is sitting around $67 per share. At the time of my hypothesis, VLO had a PE of close to 7, and currently has a PE of 13. A 13 PE isn’t bad at all if you take it at face value. However, comparing it to the industry mean PE, where does it sit? Square in the middle, 50%. The average PE ratio of the oil industry is 13.76. So, if one was to buy a company squarely on the number of the PE ratio, someone could end up buying an oil company trading at 18 times earnings, yet is still considered overvalued when compared to its peers.
Bringing it back to retail, lets see how the industry compares in terms of PE ratios. The industry mean PE ratio for retail is 20.97, significantly undervalued compared to the S&P (but then again, what isn’t higher than the S&P). Price to Book ratio is 1.69 for the industry, and price to free cash flow ratio is 16.78.
Keeping these numbers in mind, the value investor can be better prepared to find deals on an industry specific basis. When an industry has undergone a massive downturn, it does no good looking at individual companies against the S&P, in fact, even in bad economic times as a whole, it isn’t good looking at companies against the S&P, then the investor becomes a de facto S&P Index.
In order to steer clear of the Value Traps that are presented in industries such as Retail right now, it is important to analyze each company on a case by case basis, not even thinking about its relation to the S&P, and instead, compare the strength of the numbers of the individual securities to that of its industry and sector.
Be on the lookout for a future article where I go in depth on a couple of companies within the Retail industry specifically, and where I am finding discounted value.