3 Bargain Stocks for This Market

In "70 Times Better Than the Next Microsoft," my colleague Bill Barker revealed which category of stocks outperformed from 1927 to 2005. Given the insane market volatility we've experienced recently, I've updated Bill's numbers through the end of 2008 to see what critical lessons we can draw:

Category

Value

Growth

Large Cap

10.9%

8.9%

Small Cap

13.6%

9.0%

Source: Kenneth French. Categories are based on market capitalizations and price-to-book multiples.

This data comes from highly respected scholars Fama and French, and it has powerful implications for investors.

It shows that over an 81-year period -- hardly an outlier -- value stocks outperform growth stocks, and small stocks outperform large stocks. The best-performing category was small-cap value stocks, by a wide margin.

How wide?
Those may look like small percentage differences, but with compounding, those small percentages add up to mind-boggling amounts of money. Here's how much $100 invested in 1927 in each of these categories and rebalanced annually would be worth today:

Category

Value

Growth

Large Cap

$437,860

$97,682

Small Cap

$3,086,003

$103,798

In other words, after 81 years, investing in small-cap value stocks would have yielded anywhere from 7 to 31 times as much money as any of the other categories!

A big reason for small-cap value's dramatic outperformance is Wall Street's constant obsession with large, prominent firms -- like today's McDonald's (NYSE: MCD  ) and Yum! Brands (NYSE: YUM  ) . Both are fantastic operators, but when hunting for bargains, investors should keep in mind that more prominent stocks such as these are far less likely to be mispriced than somewhat obscure small caps like Buffalo Wild Wings (Nasdaq: BWLD  ) .

It's no accident, after all, that every one of the market's 10 best-performing stocks of the past decade was a small cap.

And when you combine a group of stocks that tends to be mispriced (small caps) with a group of stocks trading at low valuations (value), you're likely to find some great bargains.

Here's why
When a closely watched company appears cheap, there's often a good reason for it. That's why in a September column, "Don't Touch These 3 Huge Value Traps," I warned investors to stay away from Citigroup (NYSE: C  ) , Lehman Brothers, and Wachovia.

Despite the fact that they were trading at or well below book value, these were closely followed institutions dealing with continuing write-downs, managerial missteps, and deteriorating businesses. With so much interest in their condition from Wall Street hot shots -- each had more than 15 analysts following them -- it seemed likely their share price declines were justified.

That may not be the case for small caps. In fact, research cited in The Wall Street Journal, along with my own findings, show that small caps tend to outperform when the market rebounds.

Why? Because small value stocks are less closely followed by professionals, they are more likely to be mispriced. So, when times are tough -- and times have been tough since late 2007 -- that mispricing means that small caps are punished beyond justification.

What to look for today
This isn't to say that small stocks are low-risk. Indeed, if this market has taught us anything, it's that every stock has risk. But the data does indicate that size itself isn't a great measure of safety.

Since this recession began, the small-cap tracking Russell 2000 index has performed basically in line with the S&P 500. And when we examine fallen giants such as Citigroup, Bank of America (NYSE: BAC  ) , JPMorgan's (NYSE: JPM  ) prey WaMu, and the assets formerly known as Lehman Brothers, we see that risk has less to do with whether a company is large or small, and a whole lot more to do with heavy debt levels, shoddy executive compensation structures, unwieldy and arcane business units, or unprofitability.

In light of these facts, investors should consider buying companies with:

  • Little or no debt
  • Heavy insider ownership
  • High profitability

In fact, these are all qualities that Warren Buffett says he looks for. So, taking the lessons from the Fama and French data, and with a debt of gratitude to Buffett, I've selected three small-cap value stocks (each has below-market-average price-to-book value multiples -- Fama and French's value metric) that share those qualities:

Company

Market Capitalization

Price-to-Book Ratio

Debt/Equity

Insider Ownership

Return on Equity

American Oriental Bioengineering (NYSE: AOB  )

$344 million

1.0

37%

21%

15%

Gulfmark Offshore

$724 million

0.8

56%

11%

24%

AgFeed Industries

$155 million

1.1

3%

42%

25%

Data from Capital IQ, a division of Standard & Poor's. Data through April 30, 2009.

Of course, these three bargain stocks aren't official recommendations, but they share many qualities that make for great investments and are excellent starting points for further research. Moreover, they hail from the small-cap value quadrant, the category that has outperformed all.

Some more ideas
Eighty-one years of historical data confirms that small-cap value stocks tend to outperform over the long haul. Research also shows that if you're going to be looking for great small-cap stocks, now is a particularly great time to begin bargain-hunting.

Our Motley Fool Hidden Gems team looks exclusively at small caps with limited analyst coverage, little or no debt, and dedicated leadership. With stocks so cheap, they're seeing some incredible bargains today. If you're looking for more ideas, click here to read all about our favorite small cap stocks, free for the next 30 days.

Already a Hidden Gems subscriber? Log in here.

Ilan Moscovitz owns shares of Buffalo Wild Wings and AOB, but no small kittens. Buffalo Wild Wings and AOB are Hidden Gems selections and Motley Fool holdings. AOB is also a Global Gains selection. The Fool's disclosure policy is crazy for Pounce!


Read/Post Comments (17) | Recommend This Article (207)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 06, 2009, at 2:34 AM, blueheron999 wrote:

    Well, here we go again... don't buy C, which many of us did at a low price after it was trounced by the talking heads due to the irrational fear of government takeover.

    It ran up very fast--seems to have an uncertain future now--so lots of us have sold it. Same with BAC, for which the late news has not been kind.

    Motley fools? I'd say, however bright your costumes are.

  • Report this Comment On May 06, 2009, at 9:34 AM, howboutme wrote:

    81 year numbers always look good if you spin it the right way. I think you left out one important quality of measure, you have to buy the right small cap stocks to get to that number. Small cap stock purchasing is hit and miss, you would be better off buying mutual funds if you want to see those returns. What I really need are solid recommendations, do I get in the market now or hope for another down turn,.....which everyone keeps talking about but the market won't give it up that easy and the recession time period is almost up. The average recession period time frame is on its back half- up side. If you didn't get into the market in March, you already lost big returns.

  • Report this Comment On May 07, 2009, at 9:57 AM, Buckeye46 wrote:

    Well said, howboutme, especially about getting in at March. All this hokus pokus boils down to buying low when you know it's solid company and the market is just temporarily insane.

  • Report this Comment On May 08, 2009, at 1:20 PM, evalsmed wrote:

    And how many of us hold for 81 years!! Or even a quarter of that time. Absurd!

  • Report this Comment On May 08, 2009, at 2:22 PM, memberofwhat wrote:

    I would comment on some articles but everytime I try to access I find that my membership doesnt include that, but they would gladly sell me one.....

  • Report this Comment On May 08, 2009, at 3:25 PM, brow0905 wrote:

    So much hatred for the fool out of you commentors. I mean this is a for profit company. You did sign up to recieve their either weekly or daily free newsletter. And in this article they not only gave you a few ideas of some interesting small caps but also presented a link for a free newsletter for their 3 picks to cash in on Obama's stimulus plan. Oh by the way they fully disclose what positions they hold in any they ever mention in an article. What more do you clowns want?

    Seriously if you don't like it unsubscribe. But rather than listening to you dolts constantly complain about getting a sales pitch why don't you save the whining for your wifes or husbands and bring some interesting commentary about the equities mentioned above to this board.

  • Report this Comment On May 08, 2009, at 3:52 PM, smaulcap wrote:

    Gee.....Where have I been?

    I didn't know JPM and BAC were "fallen giants." I thought they were just giants. Neither of them have fallen for me. For the past 5 or 6 weeks they have been rising giants of mine. I have been making loads of $$$$$$$$ trading JPM and BAC. Glad I didn't fall for that "government take over" crap. I never bought it for a minute. All that fantasy talk did was drive the price down, and make the stock affordable for me. GS too, that has been another big winner for me. I love it!

    If this is what it's like doing business with fallen giants, give me more. More more more. I want more!

    I know, I know......I'm missing out on the Marvel Comic Book Company (MVL) It's up a whopping 0.06% $0.02 as I write. JPM up 8.94% $3.15

    Gotta go now.....Time to cash in my JPM chips.

  • Report this Comment On May 08, 2009, at 4:07 PM, buddylady wrote:

    Please give a threshold for when to sell these three new suggestions since they are not " official picks " we have no idea how long to hold on.

    Tks,

    Bill

  • Report this Comment On May 08, 2009, at 4:16 PM, Spartan201 wrote:

    "but when hunting for bargains, investors should keep in mind that more prominent stocks such as these are far less likely to be mispriced than somewhat obscure small caps like Buffalo Wild Wings (Nasdaq: BWLD)."

    BWLD mispriced? With the stock trading at roughly 24X 2009 consensus EPS estimates, and same store revenue growth projected at 3-4%, where is the value? Granted, BWLD has some positive aspects (no debt), this is a piece of coal instead of a diamond in the rough. (Maybe the reason that consensus is a "sell").

  • Report this Comment On May 08, 2009, at 5:34 PM, michaelbinCA wrote:

    For profit companies. For profit investors.

    F was $1.01 on 11.19.2008.

    C** was less than $1.

    AIG was less than $1.

    What did these close at today, 5.8.2009?

    ** Didn't take me very long after reading about an INSIDER buying 16,500,000 shares.

    Bought THEN, sell today. Not bad for a small time dude like myself.

  • Report this Comment On May 08, 2009, at 6:14 PM, Oakmanbob wrote:

    I am a very small investor but I bought Citigroup at $1.67, sold half of it at $3.35 so I have $0 invested now that I will just hold. Even if it goes to $1.00 again, I am that much ahead.

  • Report this Comment On May 08, 2009, at 7:45 PM, jtofabc wrote:

    AND HOW ARE YOU GOING TO ACHIEVE THESE GOALS IF YOU SELL SMALL CAPS AS THEY GROW SUCH AS YOU HAVE WITH BWLD AND SNS FOR EXAMPLE.

    OLD JIM

  • Report this Comment On May 09, 2009, at 5:03 PM, wonderousdragon wrote:

    This is all great reading and the guys commenting are so wise and savvy in their investment thoughts and means.

    I think I'll just sit back, keep reading and see if the market is going to take another big dive on us fools.

  • Report this Comment On May 10, 2009, at 11:00 AM, Ibeatmykids wrote:

    I like small caps. It makes my porfolio more interesting and it is nice to think that in the future I could have a 50 bagger or more on my hands. Of course they could go the other way but I try my best to dig out some good qhality ones. For example one that I am proud of digging up is UTVL.OB or just UTVL depending on where you look it up. I have high hopes for this one.

    I also agree with all of the complaining on these comments recently. There seems to be alot of misplaced grumpiness out there.

  • Report this Comment On May 10, 2009, at 11:11 AM, IIcx wrote:

    try a stock search on "Fool" for stocks that are between 1-15% of their 52 week lows and you're going to find some interesting surprises. It looks to me like the money has fled many of the safe haven names.

  • Report this Comment On May 12, 2009, at 12:12 AM, dlphi50 wrote:

    There aren't ticker symbols for the second 2 stocks he picked: I searched for Gulfmark Offshore and AgFeed Industries and came up empty. What gives?

  • Report this Comment On May 12, 2009, at 6:23 PM, dpv55zx wrote:

    (NYSE:GLF) is the symbol for Gulf Mark

    The company website link.

    http://www.gulfmark.com/fw/main/Home-3.html

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