Distinguishing an opportunity from a value trap

WHAT ARE WE LOOKING FOR?

The past two days we have been examining lists of stocks recommended by various brokerage firms. On Tuesday, we looked at the portfolio of 12 larger-cap Canadian stocks compiled by UBS Securities Canada strategist George Vasic. Yesterday, we returned to the list of top picks for 2008 drawn up by analysts at Raymond James Ltd. at the end of last year to check up on their progress. Today, we look at a list of low-multiple Canadian stocks that Myles Zyblock, at RBC Dominion Securities Inc., sees as offering opportunity to investors.

WHAT MAKES A STOCK A VALUE OPPORTUNITY?

Mr. Zyblock feels that now is a good time to add some value-driven ideas to stock portfolios given the noticeable decline in market prices in the last several months. But he points out, not all stocks with low price/earnings multiples represent an opportunity; some are actually value traps. Being able to figure out which is which is crucial, Mr. Zyblock found, because only about half of the stocks in a portfolio constructed solely on the basis of low P/E actually beat the benchmark. Forty per cent continue to decline in price over the following quarters. Those are the dreaded value traps.

"Of course, differentiating between a value opportunity and a value trap before the fact is never easy," he said in a recent report. "However, we find that performance among a low P/E constituency is much improved when these companies also display a high degree of fundamental momentum and/or predictability," he said in a report last week. Predictability is judged based on stability of total return and profit, earnings estimate confidence and low non-recurring item frequency. Momentum meanwhile is determined by the momentum of earnings, revenue and total return as well as positive earnings estimate revisions and positive earnings surprises.

WHAT DID WE FIND

The list features a mix of stocks. Financials figure prominently with stocks such as Fairfax Financial Holdings Ltd., Industrial Alliance Insurance and Financial Services Inc., Sun Life Financial Inc. and Northbridge Financial Corp. showing up on the list. But only three banks made the grade and one of them is a smaller player in that market - Laurentian Bank of Canada.

Two energy issues also made the list; so too did two media companies and two consumer discretionary issues.

Dorel Industries Inc. and Power Financial Corp. show up on both the top and bottom portions of the list.

SOURCE: GLOBE INVESTOR