Beware the 'value traps': Bank of America details red flags to watch for when hunting down cheap stocks

Mike Segar/ReutersA man crosses a nearly deserted Nassau Street in front of the New York Stock Exchange (NYSE) in the financial district of lower Manhattan during the outbreak of the coronavirus disease (COVID-19) in New York City, New York, U.S., April 3, 2020.
  • Bank of America recommends value stocks over growth names as major indexes breach record highs, but warns that value traps could damage investors’ portfolios.
  • Value traps are stocks that seem inexpensive but are more likely to continue falling than stage a comeback.
  • Bank of America searched for stocks with relative prices falling faster than their earnings, and found that real estate investment trust, telecom, and multi-utilities stocks screen as value traps.
  • Investors should pick high-quality names with strong price momentum and fundamentals within the value space, the bank’s analysts said.
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Bank of America’s analysts prefer holding value stocks over more expensive growth names, but see a handful of traps dotting the investing landscape.

Several gauges used by the bank identify the stock market as extraordinarily expensive. For one, the S&P 500 sits at record highs roughly five months after bottoming out on virus fears, despite the pandemic’s economic damage still looming.

Stretched valuations across the market’s darlings leave the best opportunities in value picks, the team led by Savita Subramanian said in a Tuesday note. However, certain inexpensive stocks pose a major threat to investors and should be avoided at current levels, they added.

The bank screened for companies and sectors that are inexpensive because relative prices are declining faster than their earnings. Though such stocks may seem like appealing buys at first, the analysts warn that their earnings deterioration can continue and leave investors with a rapidly depreciating asset.

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Some sectors are fraught with traps specifically due to possible de-rating on pandemic-related risks, the team said, including real estate investment trusts. Others, such as telecom and multi-utilities stocks, have simply underperformed the broader market for too long, and generally need an external booster to drive shares out of their downward spiral.

The firm named KeyCorp,Prudential,Unum, and Welltower as just some of the value traps to be wary of due to below-median forward earnings, revision trends, and price momentum.

An easy way to separate the traps from the healthy picks is by screening for market quality, the analysts said. Traditionally cyclical sectors including autos, metals and mining, and semiconductors present strong value opportunities, the bank said, as their fundamentals and price momentum set them up for gains down the road.

Some of the bank’s recommendations for “quality value” stocks include Microsoft,Alliant,Cisco, and Broadcom.

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