Investment Approaches With Exceptional Returns

Christopher Browne, author of The Little Book of Value Investing, is one of the legends in the field of value investing. Recently, I had the pleasure of interviewing him for our Hidden Gems small-cap investing service. Doing so was a reminder to go back and reread the Tweedy, Browne semi-manifesto and roadmap to superior investment returns, What Has Worked in Investing: Studies of Investment Approaches and Characteristics Associated with Exceptional Returns (link opens a pdf file, Adobe Acrobat required).

That document is a wonderful compilation of some of the most important studies of both domestic and international stock market returns. Investors of all levels of experience can benefit from it. It's free as well, which makes it particularly nice for the cost-conscious.

The pdf sometimes takes a bit of time to download, but let me sum up the findings if you're in a rush. According to the research of Tweedy, Browne, there are five characteristics that tend to mark superior investment opportunities. They are:

1. Low price in relation to asset value (low P/B).
An often-ignored marker of value, but proven over many studies, a low price-to-book ratio shows there are real assets underlying an investment. This approach was central to the early work of fabled investor Benjamin Graham. Widespread diffidence to this historically proven principle contributed to the run-up in the stock market from 1997 to 2000 and subsequent return to normalcy.

2. Low price in relation to earnings (low P/E).
Selecting stocks with a low price-to-earnings ratio is probably the best known method for looking for cheap stocks. Though earnings and earnings growth ultimately do not have the same relevance for finding exceptional stocks that analyzing cash flows do, earnings still end up being quite important.

3. A significant pattern of purchases by one or more insiders (officers and directors).
This information should hardly be surprising. When the top executives or directors at a company are buying the company's shares on the open market, they are doing so with better information than the market has about the company's operations. Take note.

4. A significant decline in a stock's price.
The list of 52-week lows is one place to find stocks that are trading at low points. Running screens of companies that are 40% or more off their 52-week or three-year highs will also provide you with a good list of ideas.

5. Small market capitalization.
Small-cap stocks, of course, have historically outperformed large caps. When you combine small caps and general value metrics together you get a particularly potent form of market outperformance potential.

What the combination looks like today
As the introduction to the Tweedy, Browne study notes, "It has not been uncommon for the investments in our portfolios to simultaneously possess many of the above characteristics."

So let's look at what that translates to today. Here are some potential investments that pass all of these screens at the moment.

Let's face it. These companies aren't showing the level of insider buying that would really inspire someone, but that's one of the problems with running a screen that requires a check box for five different entries. Screening for companies that meet many, instead of every one, of these requirements might expand your choices quite a bit more.

Also the strategy of buying companies that have seen a significant decline in stock price is always going to turn up companies that appear to be in serious trouble -- as a number of these do appear. That's why they trade at fractions of previous prices. But it's comforting to know that history shows they have a tendency to come back, and not only to come back, but to beat the market when they do.

What the combination doesn't look like today
For comparison's sake, here are a number of companies that fit into the exact opposite set of parameters -- high P/Es, stock near a three-year high, large market capitalization, and high P/B. I've skipped including the opposite of insiders buying, as sales by insiders aren't necessarily an indicator of trouble (though they can be). Insider buying is much more highly correlated with good times ahead than insider selling is of bad times. Here's what floated to the top of the list:

That isn't to say that any one of these is a poor investment. The fact that this screen specifically includes companies that are within 10% of their three-year highs means each of these companies is perceived by the market to be doing things right. But it must be said that for these companies, as a group, to outperform the market means for them to defy the law of averages. Investors sitting on juicy profits from this list might want to consider how to position a portfolio to include some new ideas that aren't as risky.

The Foolish bottom line
It is comforting to know -- or to be reminded -- that these metrics are what has historically worked. In the Hidden Gems service, we only look at small-cap investing opportunities, and we spend a lot of time on companies that pass many of the typical value metrics. And much like the fine people at Tweedy, Browne, we've been successful in turning our research into market-beating returns. In our case, the results are 51% versus 22% realized by the S&P 500 over the same time period.

Like What Has Worked in Investing, you can read all of our work, market-beating ideas, and investor community discussion for free during a 30-day trial period, with no obligation to subscribe. Just click here for more information.

Bill Barker does not own shares of any company mentioned in this article. The Motley Fool has a disclosure policy.