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I'll bet dollars to doughnuts you've never heard of Lakonishok, Shleifer, and Vishny, unless you're a total investing dweeb like me. But before they founded LSV Asset Management, which now has $51 billion under management, they were obscure academics about to publish a very famous paper. Best of all, the insights they discovered can help you find stocks that will stack the odds of a successful investment in your favor.
Turning investing upside-down
In 1994, the trio divided stocks into 10 buckets, according to earnings yield -- E/P, or the inverse of the price-to-earnings ratio, because academics prefer the exotic. LSV found that high E/P stocks -- also known as low P/E stocks, or value stocks -- beat low E/P, high P/E glamour stocks by 4 percentage points per year.
LSV next divided stocks into groups using a formula based on sales growth. Amazingly, they found that boring businesses with low sales growth outperformed flashy high-growth companies by 7.3 percentage points per year.
Best of all, LSV found that a portfolio combining the high E/P and low-sales-growth approaches outperformed its opposite -- high P/E, high-growth stocks -- by 11 percentage points per year!
I keep LSV's formula in mind every month when I'm selecting dividend stocks for my Income Investor newsletter. Let's use it right now to dig up a slow, cheap, and potentially outperforming value stock for your own consideration. I used data from Capital IQ (a division of Standard & Poor's) to unearth companies trading at a P/E less than seven, with sales growth of less than 3% last year. Here's one that came up:
Result: American Financial Group (NYSE: AFG )
American Financial Group is a property and casualty insurance company that, ironically enough, is 5.45% owned by LSV Asset Management itself. However, the firm also sports heavy ownership from a single family (two brothers and their father, who serve as co-CEOs and chairman, respectively) -- and faces a tough insurance market these days. The tough climate has made selling insurance hard, leaving the company to profit from its investments -- which are on the risky side. While this company may be cheap for a reason, the time to make money in insurance won't be when all the stars appear to be aligned for the industry.
Speaking of the industry, for some comparison, Fidelity National Financial (NYSE: FNF ) , an acquisitive title insurer that's also the nation's largest, trades at a P/E just north of 11. Assurant (NYSE: AIZ ) , a diversified insurer with a penchant for specialty underwriting and which isn't terribly leveraged, goes for about nine times trailing earnings. Cincinnati Financial (Nasdaq: CINF ) , a former recommendation in my Income Investor newsletter whose shtick is peddling its property-casualty insurance through a network of independent agents, has a P/E just below nine. And thanks to recent low earnings (admittedly improvements on the losses they followed), general insurer Old Republic International (NYSE: ORI ) sports a high P/E of 52 -- a good reason to look at the financial statements of any stock before getting into a tizzy (Old Republic normally trades closer to 10 times earnings, so the market expects earnings to rise).
Returning to American Financial Group, I can't advocate buying it -- or any stock -- blindly, but considered in light of LSV's findings, it may have better than average odds of outperforming.
If you scan the news articles on value stocks, you'll see plenty of reasons not to invest. But according to LSV's findings, those same reasons have already driven many investors away from stocks like American Financial Group. Thus, a company facing headwinds can get priced so cheaply that it actually becomes a good investment. Things don't have to go exactly right; they just have to turn out better than the market expects. In short, companies with low expectations can give you the best chance to score a truly great investment.