We live in a society of excess. We eat too much food, drink too much booze, drive too many cars, have to sift through too much information (this article notwithstanding, of course), and are just plain given too many options. Turn on the TV, and you've got too many channels. Looking for a cell-phone plan? It takes a week to consider your choices, at least if you move at my pace.
Investing is, of course, no exception. Say, for a given chunk of your portfolio, you've ruled out bonds, money market funds, and the more than 12,000 mutual funds out there. Instead, you'd like to focus on stocks. Say hello to the 10,000 or so to choose from.
Naturally, intuition alone will eliminate a good many. Don't want micro-sized risk buckets? Shave off a few thousand there. Not angling for large caps? There go a bunch more. And so forth. But even intuitively, the range of stocks that might be appealing to most people is still insurmountably broad.
I know from emails I've received that most of you aren't scoping for some predefined, arbitrarily specific set of criteria when it comes to individual stocks for your portfolio. You just want stocks that will make you money. You're willing to be flexible with criteria -- large cap, small cap, growth, value -- if a stock gives you a decent chance at scoring in a manner somewhat commensurate with the risk involved.
Stacking the deck
Problem is, you don't have a ton of time, and you're not keen on reading up on dozens of stocks. Sure, you can use a screener to prune the stock lists down, but although screens give at least the appearance of exclusivity, they can be disturbingly arbitrary. It makes sense to stack the deck in your favor by screening for groups of companies statistically shown to deliver more bang for your risk-adjusted buck than others. Amazingly, such companies aren't myth; they're reality, and I'll tell you why.
The Wall Street crowd (of which I was formerly a part) has been tossing around increasingly sophisticated ideas about risk vs. reward -- the standard, most basic trade-off in investing. It's hard, though, because risk is in the future; we can't even define it, really, and the best we've been able to do is extrapolate past events and tendencies in hopes they may offer a reasonable window into the probability of future loss. Before it got to Wall Street, most of the current risk vs. reward fodder came from academia, where the prevailing wisdom was that, because of market efficiency, higher reward was inseparable from higher risk.
And generally speaking, it is. But while academic extremists were insinuating the futility of picking individual stocks (the old and overused joke goes that such an "efficient market" theorist wouldn't stop to pick up a $20 bill on the sidewalk, because, he reasons, if it were real someone would have already grabbed it), investors like Warren Buffett were flagrantly (and profitably) ignoring their warnings and seeking undervalued stocks -- that is, stocks trading below for what they should given their risk levels.
Small firm effect
Even within academia, cracks in the theory were beginning to emerge. The first big one came in 1978, with then-graduate student Rolf Banz's finding that small caps as a group did better than they should, at least according to their variability. Subsequent academics confirmed this. If you're interested in Googling (NASDAQ:GOOG) them, some pairs of names (academics like to work in clusters) are Arbel and Strebel as well as Wilson and Jones. Other apparent anomalies -- such as the January effect and the Monday effect -- emerged, but have since been traded away following the transpiration of their potential for "abnormal" (academics don't like to use words with emotional connotations) returns to the markets.
But the small firm effect stayed. Why, you ask, was it not immediately exploited to the point of no longer being abnormally profitable, as happened with the January and Monday effects? The gist revolves around simple practicality: Small firms aren't efficient places for institutions -- the big, "smart" money in the market -- to invest considering the limited investment sizes (they can't buy as many shares as they'd like, at least without driving the price into the stratosphere) and research effort required. Also, the information flowing about these companies is usually not as thorough and circumspect as with large or mid caps; this "information asymmetry" keeps other investors -- who might have driven prices up -- at bay.
Academics still like the idea of making a buck, even an imaginary one. More recent studies have sought to identify trading strategies that, albeit in retrospect, would have successfully capitalized on the small firm effect's abnormal returns. Some of these strategies work, and quite well. In fact, some are in the works at top Wall Street firms.
According to the academics, aside from a small market cap, another common trait among these top performers is a low price-to-book ratio -- the beginnings of a value investment. But low P/B companies are often shunned for good cause; enough succeed to make them profitable fodder for academic portfolios, but many keep declining into the land of no return(s).
Where am I going with all this? Actually, to an idea you can take straight into your portfolio, one that will save you research time -- not to mention boost your odds -- by delivering not individual stocks but groups of stocks that, according to academia, are more likely than others to cheat the risk/return trade-off. From there, you can target individual companies for further research.
As a start, I ran some simple screens (you can do the same) targeting small caps trading at low price-to-book ratios. These are the market's unloved. But since I wanted the low P/B stocks most likely to recover from whatever plight sent their multiples so low in the first place, I threw in some criteria like low debt and/or manageable interest expense and positive operating cash flow. The result is two stocks that might make for decent long positions -- although one has a pretty big risk you should be aware of (of course, it has a pretty cheap price, too). For kicks, I tried the reverse too, flipping the debt and cash flow criteria around to find two low P/B stocks that have fallen and might not get up; these stocks could make for good shorts, or at least stocks to avoid.
Bear in mind that these are the computer's picks at heart, not mine. Sure, I singled these out from the screen results as being particularly interesting starting points, but it's just about as easy for you to do the same to generate your own "of-interest" lists. And remember, even if you're playing with better odds, you're still gambling. In other words, nothing is a sure thing, especially this set of stocks. With that being said, here you go:
Possible longs
USG (NYSE:USG) makes wallboard, ceiling tiles, and joint compounds. Nothing sexy here, folks. But its P/E is dirt cheap and return on equity is high for a low-P/B stock. This stock has seen some volatility, so prepare for that, and take the time to read up on the big reason P/B is so low -- the company's asbestos-related bankruptcy issues, and make sure you've got the stomach for the shareholder risk it brings. Market cap is $800 million.
ShopKo's (NYSE:SKO) reputedly lame discount store offering is tempered by the fact that, as with Kmart (NASDAQ:KMRT), its real estate alone is enough to justify more than the current price, at least in theory. If a turnaround does happen, it could be a nice bonus. Market cap is $525 million.
Possible shorts
LaBrance & Co. (NYSE:LAB) provides specialist and market-making services on various stock exchanges. This $500 million market-cap company is facing a bleak income picture and the prospect of business deterioration with a possible move away from specialists. Watch out for its large cash hoard.
USEC (NYSE:USU) supplies uranium to nuclear power plants and also salvages it from nuclear warheads in Russia. This $900 million market-cap firm sports measly margins and a high P/E. Worries? It pays a dividend, which would make it more of a stock to avoid than a pure short in my book.
James Early isn't the only one aware of the market's back door to returns. Tom Gardner's been practically proving its existence with the outstanding returns of his small-cap-focused Hidden Gems newsletter. You can check it out free.
James Early's interest in these stocks is purely academic. He owns none of the securities mentioned. The Motley Fool has a disclosure policy .
