Something extraordinary happened this year. Something so extraordinary, it has only happened on four other occasions since 1927. Something that over the past 40 years has made investors bags of money.
Value stocks are down for their second straight year.
That's it?
Control your excitement, and I'll tell you why this is so significant.
Value stocks are often the cheapest stocks in the market, because they trade at depressed prices in relation to their revenue, earnings, or book value. They can be cyclical companies, companies going through a rough patch, or plain old slow-growers. Some companies, like Home Depot (NYSE:HD) and Merrill Lynch (NYSE:MER), manage to be all three at once.
But that cheapness belies their actual worth. Numerous studies have shown that these bargain-basement stocks outperform their showier and more expensive counterparts. In fact, according to Eugene Fama & Kenneth French, stocks with low price-to-book value ratios outperform stocks with high ratios by 4.3 percentage points annually.
Can't keep 'em down
Value stocks don't get knocked down often, and rarely for long. Neither the savings and loan crisis of the late 1980s, the Asian financial crisis of 1997-1998, nor the economic recession of 1990-1991 could knock these stocks down for two straight years. Not even the stagflation hydra of the late 1970s could do that.
According to Fama & French, large-cap value stocks have fallen for two consecutive years only five times in the past 100 years:
- Great Depression: 1929-1932
- World War II: 1939-1941
- Arab oil embargo: 1973-1974
- Collapse of the Internet bubble: 2001-2002
- Collapse of the housing bubble: 2007-2008
It's rare, but this kind of marketwide value depression is a golden opportunity.
The snap-back effect
See, when value stocks recover, they do so with a vengeance -- returning to the outperformance that has made them the darlings of many of our most legendary investors.
The following are the returns for value stocks after they fell for two straight years.
- 1931 return: -58% (1932: -3%, 1933: 117%)
- 1941 return: -1% (1942: 34%)
- 1975 return: 56%
- 2003 return: 35%
- 2009 return: ?
While I can't predict exactly when value stocks will recover from the current financial crises, this data suggests that you want to be invested when they do -- because their performance will likely dwarf even their usual outsized gains.
Yes, it's tough to buy right now. It might even be worse than you think for a while. But I believe the market will recover, and you'll want to profit from that recovery. And that means buying solid companies that have the capacity to ride out this market turbulence.
Bargains are out there
Even in uncertain times like these, famous value investors are seeing extreme buying opportunities. Global blue chips like General Electric (NYSE:GE), Pfizer (NYSE:PFE), and HSBC (NYSE:HBC) have all been bid down so low that their price-to-book ratios are at the lowest levels in years -- giving you an opportunity to buy excellent companies at even cheaper prices than usual.
Not only that, companies commonly categorized as "growth" stocks -- like Starbucks (NASDAQ:SBUX) and American Eagle (NYSE:AEO) -- have recently moved into the value realm. And when the share prices of good companies become undervalued, they are much more likely to go up than to go down further, despite all the negative prognostications.
The Foolish bottom line
The market may be dreadful right now, but it's creating the conditions for remarkable returns when it recovers. And that means it's time to buy.
At Motley Fool Inside Value, we're seeing a lot of compelling opportunities, including stocks trading at substantial discounts to their intrinsic value. If you'd like to find out what we're recommending now, take a 30-day free trial to Inside Value. You'll get all of our recommendations, including our five best bets for new money now, as well as a discount cash flow calculator you can use to find values of your own. Click here to get started -- there's no obligation to subscribe.
Fool analyst Andrew Sullivan does not have a financial position in any of the stocks mentioned in this article. American Eagle and Starbucks are Motley Fool Stock Advisor recommendations. Home Depot, Starbucks, and Pfizer are Motley Fool Inside Value recommendations. Pfizer is a Motley Fool Income Investor recommendation. The Motley Fool owns shares of American Eagle and Starbucks. The Motley Fool has a disclosure policy.
