Is This Stock A Medical Insurance Bargain?

I'll bet dollars to doughnuts you've never heard of Lakonishok, Schliefer, 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. Read on to see if it can make you money in medical insurance stocks.

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 unit of Standard & Poor's) to unearth companies trading at a P/E less than seven, with sales growth of less than 3% last year.

Separating the fakers from the money makers
It gets us on the LSV track, but it's not a slam dunk: Price – the "P" in P/E is something we can take at face value, but earnings – the "E" – isn't. One-off accounting items and business cyclicality can temporarily skew earnings. And while LSV's results did include essentially all low-P/E stocks – accounting issues and all -- we presumably want the true low-P/E laggards, and not statistical one-offs, to best capitalize on their findings.

Let's grab a stock – any stock – that came from the Capital IQ screen and see what we can learn.

Result: WellPoint (NYSE: WLP)
WellPoint is the largest health insurance company in the US. Its sales shrunk by 2.6% this past year. But is WellPoint a statistical one-off? A peek at its past P/E and fellow industry participants will tell us.

Industry participants can range from clone competitors to nearly unrelated businesses, but their valuations provide initial perspective.

Next, are we dealing with a temporarily low P/E? A peek at WellPoint's past reveals:

OK, we are -- but why? Aside from uncertainty over health care reform -- which affects peers as well -- WellPoint has been beset with weak-ish operations and relatively high corporate costs. Investors don't like these things. The question is whether the bad news is -- or isn't -- adequately priced in.

Generally, 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 WellPoint. 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.

Next action steps? Add WellPoint to your watchlist, or do the same for Aetna, Humana, AMERIGROUP, Coventry Health care, CIGNA, or UnitedHealth.

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