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.

Company

P/E

Annaly Capital (NYSE: NLY  )

9.3

Apollo Investment Management (NYSE: AINV  )

18.6

Blackstone

N/M

Kohlberg Kravis Roberts

27.0

Solar Capital

10.4

Ares Capital (Nasdaq: ARCC  )

3.8

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.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

James Early owns no stocks mentioned in this article. You can investigate his Motley Fool Income Investor newsletter free for 30 days. The Fool owns shares of Annaly Capital Management and has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (9)

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 September 08, 2010, at 1:47 PM, easyavenue wrote:

    I thought ACAS asset values were not pummeled because of the financial crisis, but that ACAS was ordered by a court or some GOV authority (SEC?) to revalue their assets because they had grossly over-inflated their values to appear to be in a much better financial position than they really were. In the old days we used to call such misrepresentation fraud. James, do I have my facts right?

    I agree ACAS may outperform. But if what I allege is true, would you trust your money to someone who previously purposefully misrepresented his company's assets?

  • Report this Comment On September 08, 2010, at 2:45 PM, spokanimal wrote:

    easyavenue:

    I'm not familiar with how the book value of ACAS's assets may have been written down (or up) during the crisis or what governing body regulates that for them but...

    ... I can say that if it was similar to the mark-to-market accounting required in the banking industry, it would have been archaic, so say the least.

    Since the market for bundled mortgages (CMOs) literally evaporated during the crisis, many CMOs had to be written down to as little as 22 cents on the dollar even if the overall "payment performance" of the CMO were well above 70%. As that devistated the industry, many called for revisions to the accounting rule, to no avail, and it greatly exagerated balance sheet weakness.

    I would specuate that ACAS had similar adjustments and that their required by FASB (Financial Accounting Standards Board) and expected by the company's external auditors. Clearly, there was a point when their assets' book value threatened bankruptcy.

    S

  • Report this Comment On September 08, 2010, at 7:09 PM, stevec5792 wrote:

    spokanimal,

    You are correct in the mark-to-market. Mark-to-market rules caused most of the BDCs problems. ACAS was hit very hard and debt covenants were breached. Combine the mark-to-market and debt covenant breach with the credit freeze and you have the scenario of near bankruptcy ACAS was facing.

    At the same time mark-to-market writedowns were happening, ACAS' equity and debt investments were still paying. They did increase loan loss reserves, which caused another earnings hit..

    Lastly, a "going concern" notice appeared in the auditor's report. All of these combined events pummeled ACAS.

    Now, we have asset writeups happening, some asset sales, credit is difficult but not impossible for BDCs, the debt is restructured, and Paulson bought a large equity position (diluting my shares, though). I think most of the problems are behind the company and they have a good chance of proving LSV's study correct from here.

  • Report this Comment On September 09, 2010, at 2:24 PM, InvestLong22 wrote:

    ACAS in 2010 is a really bad example for James Early.

    ACAS in 2007 had a nice dividend and flirted with $50, but was highly leveraged going into a market collapse. The lenders quickly realized ACAS was a serious problem. If there had been any sniff of fraud they would have foreclosed. Instead, they put in tight controls and watched ACAS restructure, at an enormous cost. ACAS lost 98% of its value by March 2009 (under $1) but has since recovered 10% of the territory lost. ACAS won't get back to $50, but $10 would be nice progress.

    None of this drama supports the thesis of this article.

  • Report this Comment On September 12, 2010, at 5:56 PM, 1caflash wrote:

    Ares Capital has been producing positive results in my largest account, and I increased my holdings in my tax-deferred IRA by 60% to 2,000 shares during August 2010.

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