I read a very interesting article this week by John Rubino on the topic of value traps. Here are the first few paragraphs of the article that explain the idea of a value trap:

This Time It’s Value Traps
John Rubino
6/13/2007

Most financial bubbles are pretty easy to spot: An asset class climbs way beyond what old-fashioned valuation measures used to define as reasonable, market participants start acting like idiots, and pundits rationalize the madness with learned “new era” theories. Think late-90s tech stocks or California houses in 2005 or today’s Shanghai stock market. This kind of bubble announces itself loudly, making it easy to ridicule and/or bet against.

But today’s U.S. stock market is a different, trickier, far more dangerous kind of bubble, because the stocks that are wildly overvalued actually look pretty cheap by traditional measures: Banks and brokerage houses at 12 times earnings, homebuilders at 1.5 times book, retailers at 1 times sales. In terms of historical trading ranges, there seems to be nothing here to get excited about.

But look a little closer and you see that these are classic “value traps,” stocks that seem cheap but are actually wildly overvalued because their underlying earnings, book value, dividend yield or whatever are artificially inflated. Value traps are common at the end of long expansions, when corporate earnings have spiked because of supply constraints, but stocks haven’t, as investors begin to suspect—rightly—that demand is about to slow, thus compressing profit margins and sending earnings off a cliff. Hence the juicy-looking valuations.

…

Despite the fact that the US stock market is at one of its highest P/E levels in history, the real danger here is in the artificially high company earnings that underly the inflated prices. Stocks look cheap when in fact they are expensive.

Let’s take a look at a few examples. The data below come from Valueline, Yahoo! Finance, and Marketwatch.

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Example 1: KB Homes (KBH)
Stock price: $42.18
Earnings per share: $4.13
P/E: 10.21
Price/Book: 1.31

On first glance, KBH looks like a steal, trading nearly 50% lower than its peak price of $83.45 in July 2005. Its P/E and Price/Book also both look reasonable. But let’s examine some key company statistics for the last ten years:

Sure, the stock looks cheap now at a P/E of 10.21, but it is not unreasonable that earnings might drop 50% or more in the next few years, especially given the record high housing inventory on the market right now. If earnings per share drop to the 2008 Valueline estimate of $1.55, the current price of $42.18 will produce a P/E ratio of 27.21. Who is going to want to hold KBH at a P/E of 27.21?

Pick your favorite home builder stock and the analysis looks pretty much identical. Home builders will be a bargain at some point in the next few years, but we’re nowhere near the bottom yet.

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Example 2: Goldman Sachs (GS)
Stock price: $225.89
Earnings per share: $21.43
P/E: 10.54
Price/Book: 2.79

Goldman Sachs is the 200-pound gorilla that leads a financial sector that contributes 28 percent of the S&P 500 income. I wouldn’t want to bet against the smartest minds in the business, but then again, nobody expected Long Term Capital Management (LTCM) to blow up either.

Check out the revenue and earnings growth in the past 4 years. Incredible!! But is it sustainable?

Most definitely a large part of this can be attributed to a growing securitized derivatives market, increased leverage, and a robust broader financial sector. Say what you will about Goldman Sach’s brand name, but the earnings per share dropped by a third in the 2001 recession. If the US economy experiences a similar recession in 2007 or 2008, GS earnings (and stock price) could easily drop by 50%.

Pick your favorite investment bank and the analysis looks almost identical. It seems unlikely to me that Goldman can double or triple company earnings again like they’ve done in the past few years, even if the economy stays strong. As for the downside risk, I think it’s much bigger than most people realize.

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Example 3: J.C. Penney (JCP)
Stock price: $74.11
Earnings per share: $5.13
P/E: 14.45
Price/Sales: 0.83

Ahhhhh, J.C. Penney, a retail favorite. This stock certainly has name brand recognition, but it by no means has the market power of a Goldman Sachs. Let’s check out the last decade of company earnings:

Look how much earnings suffered after the dot com bust in 2000. Why? It’s easy to spend money at J.C. Penney when you’ve got hundreds of thousands of dollars in tech stocks in the bank. But once you realize that your tech stocks aren’t worth as much as you thought, it’s just as easy to cut back on your retail shopping. Earnings per share fell 90% from 1999 to 2000, and the stock price fell 70% in the same time period.

Currently, we’re at the tail end of a housing boom that has had a similar wealth effect for consumers. With a few hundreds of thousands of dollars of home equity, who needs to save? Let’s spend money at J.C. Penney instead! But a negative national savings rate and home equity rapidly disappearing will eventually catch up to the American consumer. And the impact on JCP earnings? Kerplunk!

The artificial explosion of earnings for J.C. Penney has been even stronger in the housing boom than it was in the tech boom. The JCP stock price has more than tripled since it’s July 2003 low. Is it just me, or do things look eerily like 1999?

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So what is the point? Not only is the stock market expensive relative to earnings, but even the earnings themselves may be temporarily bloated. Rubino’s value trap analysis is right on the money, and it represents a greater risk than most stock investors realize.