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Beware of 'Value Traps' Ford, HP, SanDisk

BOSTON (The Street Ratings) -- Ford (F), Hewlett-Packard (HPQ) and Marathon Oil (MRO) are stocks that have fallen enough that they've become attractive to some investors.

But be careful -- they may be so-called value traps. A value trap is a label for a stock or industry that's cheap based on metrics that analysts follow, thereby raising their allure, yet have declined for a more fundamental reason unbeknownst to investors. So someone who buys a value trap could lose money instead of capitalizing on an expected rebound.

Financial stocks in 2008 are a shining example. Lehman Brothers and Bear Stearns appeared like smart-money values prior to their collapse, based on expected earnings. Unfortunately, some investors were left in harm's way, not realizing the true extent of the balance-sheet toxicity.

Merrill Lynch recently introduced a model to help to identify a value trap. In its research, industries are ranked on three factors: price momentum (change in relative price over three months), earnings momentum (change in relative earnings per share over three months) and earnings yield (current relative forecast EPS divided by price).

Each industry is decile-ranked within each factor, and then the rankings are totaled. An industry is considered to be a value trap if it ranks within the top five deciles for earnings yield, but it scores below the fith decile on both earnings and price momentum. For an industry to be considered attractive, it must rank at decile six or better across each of the three factors.

To get a good feel for this model, I decided to re-create it, using data from TheStreet Ratings. I've maintained the same three factors with two small changes. For price momentum, I've used an average alpha score over the past three months, which is a bit different, in that it also accounts for risk (beta) when assessing the price momentum. And for valuation or earnings yield, I've compared the current earnings yield to the six-year average (Merrill uses a 10-year average).

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