Monday, March 30, 2009

value stocks in a recession

Contrary to popular belief, value strategies often do poorly during recessions, especially relative to growth strategies.

The reason is simple: When growth is scarce, as it is in a recession, then investors pay a premium for companies that manage to keep growing. One memorable exception was the recession of 2001, when investors dumped growth companies -- mostly overpriced technology stocks -- as if they were toxic.

"It's not unusual for value to suffer in a recession," says Joseph Mezrich, head of quantitative research at Nomura Securities International. "What's unusual this time is the magnitude" of the suffering.

In this recession, the value-stock barrel has been spoiled mainly by a bunch of very bad apples: banks.

Value investors often hunt for companies that have a low ratio of stock price to "book value," which is roughly the value of their assets minus their liabilities. For various reasons, banks typically have very low price-to-book ratios, so they often turn up on the radar screens of value investors.

When the banks started taking heavy losses in late 2007 on mortgage bets gone bad, their share prices fell, which made their price-to-book ratios even lower, making them even more irresistible to value investors.

The trouble was the "book" part of that ratio: Trillions of dollars of the assets on bank balance sheets were tied up in mortgage debt, which was rapidly declining in value. That made book value a target that was moving fast in the wrong direction: down.

And that meant the stocks weren't nearly the bargains they seemed and just kept falling -- a phenomenon some analysts call a "value trap."

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