An Easy Winning Strategy?

We all want a shortcut, don't we? We know that there are lots of bargain stocks out there, especially now, and we want some help zeroing in on the best prospects for our portfolios.

Enter the folks at the Brandes Institute. They studied stocks between 1968 and April 2009 and found an impressive link between a certain characteristic and strong performance: low price-to-book value ratios.

They divided the stocks in their universe into 10 equal groups, ranked by price-to-book value (P/B) ratio. Those with the highest P/B ratios were viewed as "glamour" stocks, with lofty prices due to great demand and interest in them. The median P/B ratio for the group composed of the top 10% of these stocks was 7.69. Those with the lowest P/B ratio were more out-of-favor, and considered "value" stocks. The bottom 10% had a median P/B ratio of 0.50.

They then followed the performance of all 10 groups. The results showed that when the P/B ratios for value stocks were extremely low compared with those of glamour stocks, value stocks showed the greatest excess return: a staggering 17.5% annualized over the ensuing five years. That's a huge difference.

Putting it to work
This is exciting, because it suggests that we'll find long-term winners for our portfolios by seeking out the companies with the lowest P/B ratios, and that can be done easily via stock screeners. With our Motley Fool CAPS screener, for example, I searched for five-star companies (out of five stars) with P/B ratios of 1.0 or less. Here are some of the results:

Data: Motley Fool CAPS, Yahoo! Finance.

Hold those horses!
But wait -- that's not exactly right. To try and get the best results using the study, you shouldn't look among top-rated companies. Instead, you should focus just on getting the lowest-P/B stocks you can find. When I do that, I get lots of companies with lower CAPS ratings, such as Bank of America (NYSE:BAC) and Sprint Nextel (NYSE:S).

Here are some of my concerns about the study and its results:

• Studies such as these that seem to offer winning strategies can be problematic. As the report itself notes at the bottom of most of its graphs and tables: "Past performance is not a guarantee of future results." Even though it analyzes data from a long span of time, the timeframe during which you invest may feature stocks behaving differently.

• Studies like this can be accused of "data mining" in a negative sense, where people study stocks' characteristics and past performance and look for patterns. Often, they draw questionable conclusions. Some patterns discerned may be random. If you look back at weather records, for instance, and find that category 5 hurricanes happen on Tuesdays more often than on any other day of the week, that doesn't mean the future will hold the same pattern.

Finally, understand that book value isn't what it used to be. It once gave you an idea of a company's market value, when most assets, such as factories and land, were capital-intensive and appeared on the balance sheet. Today, however, as America's economy has become less industrial and more service-oriented, book value is a less-relevant measure for investors.

Consider Microsoft, for example. Yahoo! reports its recent book value at about $41 billion. But that's far from a fair value for the company, given that it has a market value north of $260 billion and holds more than $36 billion in cash and cash equivalents. Much of Microsoft's value stems from assets that don't register significantly on the balance sheet -- its intellectual property, talented employees, strong brand, and phenomenal market share, for example. Book value can be problematic for industrial companies, too, such as when their real estate property is depreciated on the balance sheet, but actually goes up in value.

So don't bet the farm based on studies like this, but incorporate their findings into your research. You might, for example, look for low P/B stocks that have a lot of other qualities you seek. As part of a smart investing strategy, looking at the P/B ratio can give you valuable insight on bargains in today's markets.

Sometimes, stocks are cheap for a good reason. Let Richard Gibbons show you some dangerous stocks that will burn investors.