We humans — particularly the American variety — love glamour and glitz. For proof, look no further than the Christmas season. TV commercials entice youngsters with images of the latest, hottest toys. They capture the imaginations of adults with ads about jewelry and iPads and bow-wrapped luxury cars. And we all wait to see how far that neighbor down the street will go this year in a quest to make his Christmas-light-covered house visible from outer space. In the investing world, glamour and glitz rule the headlines all year round. High-flying technology firms, trendy retailers pitching the latest “must-have” products, companies from the fastest-growing emerging markets — the stocks of “glamour” businesses like these are what catch the eyes of most investors and media outlets.
History has shown, however, that investors fare better by focusing on much less glamorous stocks. In fact, numerous studies show that investing in overlooked value stocks generates better long-term returns than investing in popular, high-flying growth stocks.
Why is that? David Dreman, the Canada-born contrarian guru upon whom I base one of my investment models, wrote several years ago that investor expectations were a key reason. And plenty of research supports his contention.
For example, while many have assumed that value stocks outperform because they come with higher levels of risk, one study from the Brandes Institute found otherwise. It examined how value stocks (which it defined as those with lower price/earnings ratios, using projected earnings for the next year) and “glamour” stocks (those with higher forward-looking P/Es) fared after beating or missing earnings expectations.
Its findings: “Prices rose for value stocks when they exceeded (or beat) earnings forecasts and, perhaps counterintuitively, when they missed expectations.” More popular glamour stocks, meanwhile, produced lower returns whether they beat or missed expectations, and, importantly, the trend held up regardless of whether the firm’s business was improving or declining.
That, Brandes concluded, shows value stocks outperform not because they are riskier, but instead because of behavioral biases that cause investors to put unrealistically high expectations on glamour stocks, and unrealistically low expectations on value stocks. “Over time,” the group said, “as the influence of these biases weaken, security prices revert away from extreme levels.” That means value investors who stay disciplined and rational can take advantage of opportunities caused by those unrealistic expectations.
These findings wouldn’t be surprising to many of history’s best investors. In fact, many of the greats upon whom I base my Guru Strategies were value investors who were well aware of the inefficiencies – and opportunities – that investors’ emotions and expectations create in the market. While Brandes’ study identified overlooked value plays by using P/E ratios, the gurus did so using a variety of different valuation metrics. (Each also used a variety of other variables, such as debt metrics and earnings and sales growth figures, to make sure a firm had both cheap shares and a good business.)
To see how different gurus used different valuation metrics to identify overlooked value stocks, let’s a look at a few firms that some of my value strategies are high on.
AGCO Corporation (NYSE:AGCO): Declining agricultural commodity prices have led to a rough year for agricultural equipment companies like AGCO, the Georgia-based mid-cap ($4 billion) that offers everything from tractors to combines to hay tools to grain storage and protein production systems and beyond. Lower prices mean lower profits for farmers, which means fewer equipment purchases. Tax law changes that would put much stricter limits on the amount of equipment purchases that can be immediately written off also hampered shares at times this year.
But AGCO’s shares have been hit too hard, according to my Kenneth Fisher-inspired model. In his 1984 classic Super Stocks, Fisher pioneered the use of the price/sales ratio — PSR — as a way to assess value, having found that sales were a much more stable gauge of a company’s business than earnings. My Fisher-based model likes industrial companies like AGCO to have PSRs below 0.8; at 0.38, AGCO looks quite cheap indeed. This model also looks at a number of other fundamental criteria, and AGCO doesn’t disappoint there either. The strategy likes its reasonable 37% debt/equity ratio; $3.68 in free cash per share; and three-year average net profit margins of 5.8%.
CARBO Ceramics Inc. (NYSE:CRR) — Houston-based Carbo enhances oil and natural gas well production and recovery by providing technology products and services to design, build, and optimize “fracs” used in hydraulic fracking.
My Benjamin Graham-based strategy likes Carbo ($875 million market cap). Graham, known as the “Father of Value Investing”, was a very conservative investor, and this approach looks for companies with good liquidity (current ratio of at least 2.0) and a strong balance sheet (long-term debt should not exceed net current assets). Carbo has a 4.5 current ratio, and zero long-term debt vs. $242 million in net current assets. It also trades for just 11.6 times trailing 12-month earnings, and just 1.1 times book value, passing two Graham-based value criteria.
Chicago Bridge and Iron Company N.V. (NYSE:CBI): This $5.4-billion-market-cap firm was founded more than a century ago in Chicago as a bridge designer and builder. Today, it’s based in The Netherlands, and is involved in engineering, procurement and construction services for customers in the energy and natural resource industries.
The model I base on the writings of hedge fund guru Joel Greenblatt is particularly high on CBI. Greenblatt’s approach is a remarkably simple one that looks at just two variables: earnings yield and return on capital. MyGreenblatt-inspired model likes CBI’s 13% earnings yield (Greenblatt uses earnings before interest and taxes divided by enterprise value for that) and whopping 1,086% ROC (EBIT/tangible capital employed), which combine to make the stock the 2nd best in the entire U.S. market right now, according to this approach.
Yahoo! Inc. (NASDAQ:YHOO): This “Old Tech” firm today provides a variety of products and services ranging from search to content to communications tools, generating revenue principally from display advertising and search advertising. It’s certainly had its ups and downs over the past decade, but my David Dreman-inspired contrarian model thinks its shares are a good bet. It considers Yahoo! ($49 billion market cap) a contrarian play because both its price/cash flow and price/earnings ratios fall into the market’s bottom 20%. Dreman realized that sometimes a stock is cheap because everyone knows it’s a dog, so he also used an array of fundamental and financial tests to analyze a business. This model likes Yahoo’s solid 31.3% return on equity, 2.87 current ratio, and 3.5% debt/equity ratio.
Dorian LPG (NYSE:LPG): Dorian is a pure-play liquefied petroleum gas shipping company, based in the Marshall Islands. It has 5 modern very large gas carriers and 1 pressurized LPG vessel on the water. Dorian LPG has offices in Connecticut, London, United Kingdom and Greece.
Dorian gets some interest from my Joseph Piotroski-based model. Piotroski, a little-known accounting professor, developed a method for picking stocks using the book/market ratio (the inverse of the P/B ratio). He targeted companies in the most attractive quintile of the market based on the book/market ratio, and then ran them through a variety of accounting-based tests to make sure they were cheap not because of financial distress, but because of fear, or because they were flying under the radar. Dorian’s book/market ratio of 1.09 is in the market’s cheapest 20%, and its financials look good. It has a positive return on assets (0.52%, up from -2.49% the previous year), a declining long-term debt/assets ratio (14%, vs. 66% a year ago), and improving gross margins (77% vs. 72% a year ago), all of which earn it high marks from this model.
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