How to avoid a value trap

The concept of value investing is certainly not new to investors, nor is the notion of a value trap (when the stock price takes a dive and it looks like a better value). To help to circumvent against this, investors may use momentum type indicators in combination with value metrics.

Here is one strategy that does just that. This strategy uses Morningstar CPMS* to rank stocks within the S&P/TSX 60 index on the following factors:

3M price momentum (average price over the past six months as a percentage change from the same figure three months ago)
Quarterly earnings momentum (latest four quarters of trailing earnings compared against the same figure one quarter ago)
Latest quarterly earnings surprise (the difference between the latest reported quarter of EPS, compared against the street consensus estimate just prior to the report).
5 year normalized EPS growth (this measures the rate of growth of earnings for a company over a five year period)

The first three factors above measure short term fundamental growth in the company, while the last factor measures over a longer period of time.

To qualify for purchase into this strategy, stocks must have valuations ratios in line or below the sector median valuation ratio. Specifically, I used the forward price-to-earnings, price-to-book, price-to-cash flow, and price-to-sales ratios. In the table below, a figure of 0.8x shows that the stock’s valuation is 20% lower than that of the sector to which it belongs.

What we found

I used Morningstar CPMS to back test this strategy from December 1998, to May, 2017. During this process, a maximum of 10 stocks were purchased with a maximum of 2 stocks per economic sector. Stocks were sold if any of the valuation metrics listed above exceeded 25% of the sector median, if the three-month price momentum turned negative, or if the stock surprised negatively by more than 5%. When sold, the positions were replaced with the highest ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 13% while the S&P/TSX 60 index produced 4.9%.

As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here:

Rank	Company	Forward P/E Relative to Sector Median	P/Book Relative to Sector Median	P/Cashflow Relative to Sector Median	P/Sales Relative to Sector Median	3M Price Momentum (%)	Quarterly Earnings Momentum (%)	Earnings Surprise (%)	5Y EPS Growth (%)
1	Cdn Tire Corp. Ltd. (CTC.A)	0.9	0.8	1.0	0.5	7.6	4.6	14.9	8.2
2	Magna Intl. Inc. (MG)	0.5	0.6	0.5	0.3	1.6	5.4	7.4	30.0
3	Manulife Financial Corp (MFC)	0.9	0.7	0.3	0.4	4.2	4.5	0.0	31.6
4	Weston Ltd., George (WN)	1.0	0.6	0.3	0.4	4.4	2.2	2.0	12.5
5	Loblaw Companies Ltd. (L)	1.0	0.6	0.6	0.8	4.6	2.0	0.0	11.3
6	National Bank of Canada (NA)	0.9	1.1	1.0	1.0	4.2	3.2	0.3	6.1
7	Metro Inc. (MRU)	0.9	1.0	1.0	1.0	3.4	2.0	1.8	12.3
8	Bank of Montreal (BMO)	1.0	0.9	1.0	1.0	3.9	2.4	0.0	6.8
9	Fortis Inc. (FTS)	1.0	0.9	0.9	1.1	3.1	2.6	-0.2	7.2
10	TELUS Corporation (T)	0.9	1.0	0.9	0.9	2.7	1.4	1.3	7.1
11	CGI Group Inc., A (GIB.A)	0.7	1.0	0.6	0.4	1.1	0.4	0.0	20.9
12	BCE Inc. (BCE)	1.0	1.0	1.0	1.0	1.5	0.1	0.0	3.1
13	Emera Inc. (EMA)	1.0	1.1	1.1	0.9	1.8	-8.4	0.0	13.1

* Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.

Ian Tam is the Manager of the Client Services team at CPMS, a division of Morningstar that focuses on providing high quality equity fundamental data and disciplined rules-based investment processes to the institutional buyside and investment advisors across North America. Ian completed his Bachelor of Applied Sciences (Hons. Mechanical Engineering) from the University of Waterloo in 2007 and obtained the CFA Charter in 2013.