Investors can potentially boost returns and reduce risk by steering clear of value traps, particularly by screening out low-quality stocks.

Research Affiliates conducted a study investigating the effects of value traps on investment returns and strategies for avoiding them. The study aimed to identify common traits of value traps, such as low quality and poor momentum, which can erode returns. By filtering out these value traps, investors may increase their potential gains while reducing risk. The study analyzed 32 years of U.S. equity performance covering multiple market cycles to understand how value traps affect investment portfolios over time.

The analysis revealed that by filtering out problematic stocks using momentum and quality criteria, returns improved across most companies, notably in the two cheapest valuation quintiles. This resulted in an estimated annual increase of 5.2% in the projected value premium.

Moreover, excluding low-quality stocks led to enhanced returns and lower volatility, particularly within the cheapest quintile. This strategy helped investors avoid stocks perceived as “cheap for a reason,” contributing to a more successful investment portfolio.

The research highlights the importance of avoiding value traps by filtering out stocks with low quality and poor momentum. By implementing screening strategies that identify and exclude these potential pitfalls, investors can optimize their investment returns and reduce risk exposure.

Source: “Active Value Investing: Avoiding Value Traps,” by Mario Albuquerque, CFA, Xi Liu, CFA, and Que Nguyen; Research Affiliates, February 2024.

Related

AAII How-To

How to Boost Returns by Incorporating Momentum

AAII How-To

The Eight Metrics AAII Uses to Identify Quality Stocks

AAII How-To

AAII's Quality Grade Undergoes Expansion: Looking Behind the Curtain