If you’re like me, you’ve probably been to one of these types of overhyped movies and walked away less than thrilled. The movie might not have been bad — in fact, it might have been quite good. But once the buzz surrounding a film reaches a certain level, it’s just hard to live up to the hype. Similarly, you may have been to a movie that didn’t get much hype, or even one that critics had bashed. And a lot of the time you can walk away from such a movie being pleasantly surprised. It may not have been a great film, but it was better than you thought it would be, and that leaves you in a pretty good mood.
If you’ve ever had similar experiences, you know something about what it’s like to be a value investor. That’s because, just as they play a huge role in a movie you see or a restaurant you visit or a vacation you take, expectations play a huge role in how and why value investing works.
In an interview with Barron’s a few years back, Joel Greenblatt — whose writings inspired one of my best-performing “Guru Strategies” — talked about this concept. “The way we make money as a group,” Greenblatt explained, “is that we don’t pay a lot for anything, and most of the stocks we buy have low expectations. So if the future is a little better or a lot better than the low expectations — it doesn’t have to be great — you have the chance for asymmetric returns on the upside. And, hopefully, you don’t lose much on the ones that don’t do better than the low expectations, because you didn’t pay much for them in the first place.”
Greenblatt is by no means the first to embrace such an approach. Benjamin Graham, the man known as the “Father of Value Investing” (and the mentor of Warren Buffett), recognized more than half a century ago that expectations were a big factor in stock returns. The “margin of safety” concept that guided his investment philosophy was based on the idea that stocks with high valuations (i.e., high expectations) would be hit much harder if something went wrong than would stocks with low valuations (i.e., low expectations).
History does indeed show that value stocks — which usually have low expectations — as a group have outperformed growth stocks — which usually have higher expectations — over the long haul. From 1927 through 2009, U.S. large-cap growth stocks averaged a 9.08% annual compound return, according to the data of Dartmouth College Professor and noted stock researcher Kenneth French. Small-cap growth stocks, meanwhile, averaged 9.23%. Large-cap value plays, however, averaged 11.21%, and well ahead of the pack were small-cap value stocks, which returned an average of 14.17% per year.
Of course, low expectations — whether for the market or individual stocks — aren’t inherently bullish. Sometimes expectations are low for good reason — a company is a dog, and everyone knows it. That’s why you should look not only for attractively valued shares, but also for companies that meet a variety of quality tests. Return on equity, free cash flow, and debt levels are all variables you can use to identify good, solid businesses.
After six-plus years of a rising stock market, it’s gotten harder to find good stocks with low expectations. But enough fears have lingered that it hasn’t become impossible. Here are five stocks my strategies, each of which is based on the approach of a different investing great — are high on, even though most investors don’t expect much from them. As always, you should invest in stocks like these as part of a broader, well diversified portfolio.
Helmerich & Payne, Inc. (NYSE:HP): Oklahoma-based H&P ($8 billion market cap) drills oil and gas wells for exploration and production companies. Given the huge drop in oil prices over the past year, plenty of fears are hovering over firms like Helmerich. But it has a great balance sheet — a 4.0 current ratio and $1.2 billion in net current assets vs. just $533 million in long-term debt — which helps it earn strong interest from my Benjamin Graham-based model. H&P has a 12.0 P/E using three-year average EPS (Graham used the higher of the three-year P/E and trailing 12-month P/E) and a 1.6 price/book ratio, which also impress this approach.
National Penn Bancshares (NASDAQ:NPBC): This holding company serves communities throughout a 14-county market area in Pennsylvania, as well as in Cecil County, Maryland. While it and other financials have had stellar growth over the past several years, the specter of the financial crisis has continued to hang over the sector, keeping valuations of many financials very low. The combination of strong growth and reasonably priced shares earns National Penn strong interest from my Peter Lynch-inspired model. Lynch famously used the P/E-to-growth ratio [PEG] to find cheap growth stocks. National Penn has a 14.9 P/E ratio and 36% long-term growth rate (I use an average of the three-, four-, and five-year EPS growth rates to determine a long-term rate; in the case of Penn, the five-year rate is unavailable, so I’m using the three- and four-year average). Divide that PE by the growth rate, and we get a 0.42 PEG. That falls into this model’s best-case category (below 0.5).
Winnebago Industries, Inc. (NYSE:WGO): This Iowa-based manufacturer of recreation vehicles makes motor homes, travel trailers and fifth wheel products. It has a powerful brand name — in fact, just as many people refer to any dark-colored cola as a “Coke”, people sometimes refer to any mobile home as a “Winnebago”, regardless of who makes it. While its shares were hit by a disappointing earnings announcement in March, they’ve started to rebound, and they’re cheap. WGO trades for just 0.64 times sales, impressing my Kenneth Fisher-based model. The firm has also averaged three-year net profit margins of 5.5%,. The strategy also likes Winnebago’s 50.25% long-term inflation-adjusted earnings per share growth rate, and lack of any long-term debt.
Banco Macro SA (ADR) (NYSE:BMA): Latin American markets have struggled recently, but this Argentina-based bank ($4 billion market cap) gets strong interest from my Peter Lynch- and Warren Buffett-based approaches. The Lynch approach likes that it trades for just 7.9 times earnings and has a stellar 39% long-term growth rate. That makes for a PEG ratio of just 0.2. The Buffett model, meanwhile, likes that BMA’s earnings per share declined in just 2 years the past decade, and that the firm has averaged a 23.8% return on equity over that span.
NeuStar Inc (NYSE:NSR): This Virginia-based firm ($1.4 billion market cap), a Lockheed Martin spinoff, provides real-time cloud-based information services and data analytics, enabling marketing and IT security professionals to promote and protect their businesses. It lost a big contract to rival Telcordia Technologies recently, hitting shares hard. But the model I base on the writings of Joel Greenblatt thinks it is too good a firm to take such a big hit. It likes the company’s 49% return on capital (earnings before interest and taxes/tangible capital employed) and 14.1% earnings yield (EBIT/enterprise value).