By Teresa Rivas

Amid all the Black Friday and Cyber Monday sales, bargains are everywhere. Yet if a deal looks too good to be true, it just might be -- whether it's knockoff merchandise or value-trap stocks.

With the S&P 500 trading around 22 times forward earnings -- well above its historical average -- it can be tempting to hunt for beaten-down stocks that aren't so expensive. That strategy works, but only up to a point, Trivariate Research warns.

Founder Adam Parker and his team studied the returns of extraordinarily cheap stocks by looking at companies whose valuation has plunged below 10 times forward earnings for the first time in the past five years. That group of 236 names was whittled down from a universe of the top 900 stocks by market capitalization -- excluding real estate investment trusts, energy, financial, and metals companies, which typically trade on the cheaper side already. Other criteria included companies that turned a profit in at least four of the five previous years (aside from the Covid-19 recovery period).

Trivariate found that the performance of stocks whose valuation dips below six times forward earnings is "far worse" than those whose price-to-earnings, or P/E, ratio dips below eight times, 10 times, or 12 times. That effectively makes these six-times-earnings, or "6x," stocks a far less attractive bargain.

"So 6x earnings is NOT cheap," Parker writes.

Likewise, those stocks whose P/E ratio declined to eight times did tend to outperform the broader market for a few months, but then lagged behind for the next two years on average.

However, Parker found that stocks whose multiple fell below 10 times earnings in the past five years -- we'll call them the "10x club" -- tended to turn in a performance close to the broader market over the next nine months.

"This optically low valuation is not an alpha signal," he writes. In other words, don't take that valuation as a sign that the shares are about to meaningfully diverge from the benchmark.

However revenue does matter: For the stocks in the 10x club, companies with expected revenue growth over the next 12 months do much better than those not expected to see top-line growth; the former's shares outperform the latter group significantly. Debt also appears to play a role for this 10x group: Companies with net debt greater than 50% of their market cap see their stocks lag the market and by an average of 1,200 basis points, or 12 percentage points, over the next seven quarters, according to Parker.

So, yes, there are bargains to be had, but stocks that are excessively cheap are a red flag. A stock that falls below six times is typically one where "the market on average was RIGHT to take the multiple down because revenue and earnings decline," Parker writes.

In fact, the median company that falls into the 6-times-earnings group logs a 7% decline in revenue 24 months later, and the median company in the 10x club ends up growing revenue only 1% 2 1/2 years later.

This year, Archer-Daniels-Midland, Liberty Broadband Corp's C shares, Sirius XM Holdings, Match Group, Aptiv, and First Solar have all seen their stock value dip below 10 times forward earnings for the first time in at least five years.

Stocks that hit 12 times forward earnings may be in the sweet spot, performing in-line over the next two years, and then modestly outperforming. It's also worth noting that this held true across categories, regardless of whether the stocks were growth or value names, or higher or low quality.

But ultimately, in many cases, investors get what they pay for. As always, caveat emptor.

Write to Teresa Rivas at teresa.rivas@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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December 04, 2024 04:00 ET (09:00 GMT)

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