Despite all of the pundits who say that it's impossible to beat the market, there is one simple and well-researched method that beats the market by 3 to 5 percentage points annually. That degree of outperformance is better than approximately 98% of all professionally managed money.
And I'll tell you what it is.
The value secret
I've been digging around the very helpful research, teaching, and scholarly works of noted Columbia Business School professor and value investing expert Bruce Greenwald. We've got a great series of articles interviewing him, and I particularly recommend to the patient of you out there to watch this video. It's more than an hour long, but Professor Greenwald paces up and down the hotel conference in a mesmerizing fashion that helps you watch. It's a fantastic lecture.
But I know you're busy. So let's get to it. The most captivating piece of data that he brings up in his presentation is this:
"It is true that low market-to-book all over the world -- everyplace -- has outperformed the market in every extended period at least by 3% to 5%. So that gets you a long way."
Boy, does it
Wow ... 3 to 5 percentage points per year. That degree of outperformance proves that looking for stocks with low price-to-book ratios is one of the simplest, most powerful routes to market-thrashing performance you will ever hear or read about -- anywhere.
Now, the low price-to-book metric gets tossed into every discussion about why value investing beats growth investing, but it's usually in a heap of other indicators that are bandied about, and the price-to-earnings ratio always seems to be included with greater fanfare. But it turns out that centering your search strategy around low price-to-book companies is a far more powerful component of market outperformance. Growth, as Greenwald points out in his video presentation, though receiving much of the attention of investors generally, is more often than not bad for shareholders.
Buying into low-price-to-book companies has you giving a lot more attention to companies such as CBS
It isn't that the companies with high price-to-book ratios can't end up being great performers. Professor Greenwald explains how companies such as those named above can, through "franchise value," justify their prices. On average, though, the group of significantly expensive companies (as measured by the price-to-book metric) will underperform.
The Foolish bottom line
For the most part, Greenwald considers the eternal popularity of growth investing -- despite its thoroughly researched lower returns -- to be due to the lottery effect. As he says in the last part of our interview, investors "buy lottery tickets. ... They want to invest $10 and have it be worth a million two years from now. That is clearly the biggest problem in the market." The fact of the matter, however, is that you can do better more consistently by paying less than fair value for a stock.
In seeking out precisely those value bargains, however, we, like Greenwald, advise you not to stop your research at stocks with low price-to-book ratios, even though that may get you a good long way toward great performance. You may want to pay up a little more for a stock if you find it has the franchise power that can make fantastic investments even out of expensive stocks.
We look at that power, as well as at price and the many other components that give value investors the eternal edge, in our investing service devoted to the subject, Motley Fool Inside Value. As you'd expect, it's comfortably beating the market. We invite you to take a 30-day guest pass and read about the stocks we're recommending today.
Bill Barker does not own any of the stocks mentioned in this article. Starbucks and Amazon.com are Motley Fool Stock Advisor recommendations. The Fool has a disclosure policy.
