Goldman Sachs talks value traps

European stocks have rallied sharply since the end of September, but the shift in sentiment has been especially pronounced on the continent. The Euro STOXX 50 index is up a staggering 14% versus the FTSE 100's 8% rally, and the major sea-change in investor behaviour has shown a near 90% inverse correlation with the previous year-to-date, with mining capex and industrial sectors back in demand.

The recent reversal is underpinned by three main factors, according to Goldman: an unsustainable rally in oil stocks, the market's perception of a dovish Federal Reserve, and recent attempts by China to reboot its economy.

Crucially, the oil rally is not based on a repositioning of fundamentals. Viewing the market as oversupplied, Goldman is confident low prices are still needed to restore the supply/demand balance. That will likely cause more profit pain going forward.

Some supply will be eaten up by new Chinese infrastructure projects, although Goldman predicts a "bumpy slowdown". Initial doubts about a near-term hike in US interest rates had also caused a bounce in emerging markets.

The value trap

Short, sharp rallies are commonly found in sectors experiencing secular underperformance before industry fundamentals, like margins and return on capital, have stabilised. Headwinds are unlikely to have disappeared so quickly, which makes these sectors potential value traps.

"In our view, the current momentum reversal is due more to positioning than fundamentals, and is likely to reverse. Similarly, several of the sectors that have underperformed this year to date prior to the current rotation are likely at risk of reverting to underperformance again - particularly the mining, capex and industrial sensitive sectors," explains analyst Peter Oppenheimer.

"Just because a sector has underperformed materially does not mean it represents value."

These value traps typically trade on low price/book and price/earnings (PE) valuations and a high dividend yield, but with a declining underlying rate of return on capital. Oil and gas, basic resources and utilities sectors have been recent culprits, underperforming since January 2012, July 2011 and February 2009 respectively.

Unsurprisingly, Goldman reckons miners are at greatest risk of further underperformance, while industrial and capex-related companies are under pressure from tricky oil & gas and utility markets.

Lasting for around 51 months, the average value trap underperforms the STOXX Europe 600 by 39%, despite experiencing at least three four-month rallies. In the case of the European banks, many traded on attractive valuation metrics after the financial crisis, but had underperformed by 60% over six years. Between 2006 and 2012 the sector experienced a number of rallies, including the post-Lehman Brothers crash.

"In December 2009, the sector enjoyed a 70% relative outperformance lasting around five months, after a decision by EU leaders to agree on a €200 billion stimulus plan to help boost European growth following the global financial crisis," explains Goldman.

"However, the sector returned to underperformance shortly afterwards."

How to identify the end of a 'value trap'

But for those investors who have stumbled into a trap, all is not lost. As the European banks' return on equity finally stabilised, so did the shares. It helped that the relative PE traded at a 40% discount to the market.

"It would appear that cheap valuations are a necessary but not sufficient condition for a recovery," said Goldman.

While Goldman is unable to identify a consistent single factor, it believes valuation seems an essential - but not, on its own, conclusive - condition for a recovery in a sector's relative performance. It also thinks that a change in dividends and/or return on equity seems to coincide with a recovery in many sectors after a prolonged period of underperformance.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.