Investors often love to chase the market's hottest stocks. They've swarmed after recent darlings Amazon.com (Nasdaq: AMZN ) , Research In Motion (Nasdaq: RIMM ) , and Monsanto (NYSE: MON ) -- each up more than 20% so far this year. But in their blind pursuit of the latest surging performers, investors can often leave worthy, woefully underappreciated stocks on the sidelines.
And in general, these unloved stocks offer the best chance of making you rich.
Don't take my word for it
Researchers at Dreman Value Management looked at the largest 1,500 companies between 1970 and 2006, and calculated their average annual return from a number of different investment strategies, including dividend yield and price-to-book, price-to-cash flow, and price-to-earnings (P/E) multiples.
The results were clear: Strategies focused on out-of-favor stocks, including those with low multiples or high dividend yields, handily outperformed both the broader market and the in-favor strategies. The low P/E strategy yielded the greatest gains, averaging 16.6% annual returns versus 12.7% for the market.
The beauty of low-P/E stocks
Happily for investors seeking the market's loneliest outperformers, there are lots of bargains around right now. I used our CAPS stock screener to find companies with below-market average P/Es and a maximum five-star rating from our more than 130,000 CAPS stock-raters. Here are a few of the names that appeared:
|
Company
|
Recent P/E
|
5-Year Average P/E
|
|
Arcelor Mittal (NYSE: MT )
|
4.3
|
6.6
|
|
Petrobras (NYSE: PBR )
|
11.9
|
13.8
|
|
Johnson & Johnson (NYSE: JNJ )
|
12.0
|
17.8
|
|
Philip Morris International (NYSE: PM )
|
13.1
|
N/A
|
|
Baker Hughes
|
7.7
|
16.9
|
Data from Motley Fool CAPS and Morningstar.
Low-P/E pitfalls
Of course, not every low-P/E stock will outperform every high-P/E stock. There are a number of plausible reasons why investors are willing to pay a higher multiple for earnings. Petrobras, for example, is expected to grow much faster than either Baker Hughes or Arcelor Mittal. Philip Morris pays a hefty dividend. And Johnson & Johnson is largely recession-resistant.
A quick-and-dirty way to account for the fact that not all P/Es are alike is to compare a company's P/E to its historical average. While Arcelor Mittal may have a tough year cut out for it, its P/E's position at the lower end of what it has traded for in recent years indicates that the stock may still be undervalued.
Of course, while the Dreman study indicates that the highest returns come from low-P/E stocks in general, there's much more to consider before you choose an investment. Make sure you examine a company's industry landscape, competitive position, and quality of management, among other traits.
If you're interested, you can look for portfolio candidates that have been thoroughly vetted by our Motley Fool Inside Value team. Our market-beating analysts are on the lookout for undervalued and out-of-favor companies that they believe to be worth more than the price at which they trade.
For full access to all past issues and current recommendations, try Inside Value free for 30 days.
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. Petrobras and Johnson & Johnson are Motley Fool Income Investorpicks. Philip Morris International is a Global Gains selection. Amazon.com is a Stock Advisor recommendation.The Motley Fool is Fools writing for Fools.
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