This Investment Manager Is a 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 investment company 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. Here's one that came up:

Result: American Capital (Nasdaq: ACAS)
American Capital is a middle-market finance firm that provides private equity and private debt. It's a former recommendation of my Income Investor newsletter. American Capital is run by one of the more interesting CEOs around: Malon Wilkus, who gave himself that name, is a former communist who started the company in his apartment. American Capital took a beating during the financial crisis, when asset values were pummeled and capital got tight. But hedge fund manager John Paulson has been buying recently, and it's possible that if the economy keeps recovering, American Capital -- currently around $5 per share -- may edge closer to its former highs. "Closer" being the operative word, as I'm not betting we'll see $50 any time soon.

Let's see how some of the other industry participants look.

Source: Yahoo! Finance. N/M = not meaningful due to negative earnings.

I can't advocate buying American Capital -- or any stock for that matter -- blindly. But considered in light of LSV's findings, American Capital would appear to have statistically 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 Capital. 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.