One of the biggest value traps today
Entire markets, like the Russian stock market, can also be value traps.
New investors looking at Russian stocks are sometimes drawn in by the market’s low valuations, like a low P/E ratio. Russian shares have for years traded at a much lower valuation than other emerging markets. This discount has been there for years. But it still persuades people to buy.
The graph below shows the cyclically adjusted price-to-earnings ratio (CAPE) for a range of markets. The CAPE uses the average for ten years of earnings, and adjusts them for inflation. This smooths the cyclicality of a single year P/E. It’s more difficult to calculate, but it’s a more complete valuation measure than the normal P/E ratio. According to the CAPE, Russia is the world’s cheapest stock market by far.
A lot of people think that this means that Russia’s stock market is worth buying. I recently did a quick Google search for articles in recent years about how Russian shares are a buy…based largely on the fact that they’re cheap.
The table below shows a handful of these, when they were written, and how the Russian market – based on the VanEck Vectors Russia ETF (NYSE; ticker: RSX), one of the biggest Russia ETFs – subsequently performed.
As you can see, most of the “Russian shares are cheap, buy them” recommendations were wrong. Most people who put their money into RSX saw their investment shrink over time.
Now, a value trap can stop being a value trap – and become an attractive, under-valued investment – if there’s a trigger for change. A change in management, a big change in the industry, higher commodity prices, a regulatory change – all of these things can turn a value trap into a great investment.
For a country, the trigger for revaluation – which could help close the valuation gap – can stem from political issues. In the case of Russia, as long as the perception (and reality) remains that political risk is higher than many other markets, the stock market’s CAPE will remain lower than comparable markets. (And the past weekend’s so-called elections, which saw the re-election of Vladimir Putin to a fourth term, will do nothing to reduce political risk.)
How to avoid value traps
How can you avoid value traps? For starters, don’t invest just because valuations seem low… they might have been low for a long time. Don’t necessarily take valuation metrics at face value.
In the case of companies, look carefully at a company’s debt profile. Also look for revenue growth – a company that isn’t generating more in sales every year will have a difficult time earning more money every year. Is the industry or sector as a whole growing? If not, that’s another reason why a company might have a difficult time increasing revenues and earnings.
Does the company (or country, for that matter) operate in a cyclical industry (like commodities, for example)? If so, you’ll need to time your purchase so that you don’t get sucked into a value trap. And if the company is in what’s called a structural decline, it means that demand for the business, and sometimes the industry, will never recover.
In short, cheap is usually good. But not always. Value traps can punish your portfolio even more than buying a stock that’s too expensive in the first place.
Publisher, Stansberry Churchouse Research
*This has been a guest post by Stansberry Churchouse Research*