The best stocks for a risk-averse investor are value stocks.
When you select stocks that are trading at a discount to their fair value, you're assuming they will return to that fair value. Over the long term, undervalued stocks tend to do just that. It makes sense -- when a stock becomes cheap, people notice. And when they notice, they buy it. And buying it tends to push up its share price.
For profits, all you have to do is hope it gets back to fair value. Anything over that is gravy.
Case study close to home
If you look at the picks from our value-investing newsletter service, Motley Fool Inside Value, you'll see a pretty impressive statistic. Of the 21 distinct stocks we picked last year, all but two were higher at the end of the year than on the day that we recommended them. And one of the two losers was a pick from our December 2006 issue -- it really had only a few weeks to deliver.
Now, 0.905 is a fantastic batting average. It means that if you randomly bought one of the recommended stocks last year, you had a less than 10% chance of losing money. And that's really important, because losing money gives me hives.
Of course, that's last year's news and would be nothing more than a piece of trivia, unless you delve deeper to try to understand why we were so successful. I think there were two main causes.
1. Favorable winds
One of the big factors explaining our success was simply that the market was up last year. That provided a tailwind that made it easier to achieve a high hitting percentage. In fact, about 72% of stocks in the S&P 500 were in the black in 2006.
What's more, there weren't many big blow-ups. Advanced Micro Devices
2. Cheap prices
But I don't think that the pleasant market conditions were entirely responsible for our great batting average. Stock selection was also critically important. Every stock we picked was trading at a substantial discount to fair value. On the day we picked it, our average pick was trading at a price equal to 73% of what it was actually worth.
Now, as I said, over the long haul, undervalued stocks tend to return to their fair value. It makes sense -- when a stock becomes cheap, people take notice.
In fact, when stocks get extremely undervalued, you start to see companies buying their competitors. As a result, even rumors of an acquisition can push up stock prices -- just look at how Bristol-Myers Squibb's
So, undervalued stocks tend to generate their own demand. When that happens, the shares frequently rise. Thus, by recommending stocks that were at a 27% discount to their fair value, we really stacked the odds in our favor. In a way, an excellent batting average is a natural consequence of focusing on undervalued companies.
Is there a downside?
Did our focus on buying cheap companies mean that we were less likely to find the stocks that would outperform? I don't think so. We beat the S&P 500. What's more, a couple of our picks from last year are showing better than 100% gains. Thus, it doesn't look to me as though our focus on value hurt our returns.
And it makes sense. If our picks simply returned to their fair value over the course of a year, you'd have a 37% return. If you add in the fact that most of our recommendations grow and become more valuable over the course of a year, it becomes even more obvious that value stocks can offer excellent returns at lower risk.
The Foolish bottom line
The lesson to be learned here is that, for the risk-averse, value stocks are really the way to go. Even better, you can get this reduced risk while maintaining excellent returns. So, you should target these stocks for your own portfolio, as we continue to do at Inside Value.
Are we going to have a similar batting average in 2007? I don't know -- it's a tough hurdle. But I think our value investing strategy has a fighting chance. If you're interested in seeing which stocks we see as offering the best opportunities this year, you can get a free pass to Inside Valuehere.
Fool contributor Richard Gibbons likes to make big talk about batting averages, but he has never actually been to a major league ball game. He does not have a position any of the stocks discussed in this article. Whole Foods is a Motley Fool Stock Advisor pick. The Fool has a disclosure policy.