Is Value Ready to Break Out?

Something extraordinary happened this year. Something so extraordinary, it has happened on only 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, such as building materials supplier Texas Industries (NYSE: TXI), or companies just going through a rough patch, such as Bank of America (NYSE:BAC).

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 financial scholars Eugene Fama and 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 they rarely stay down 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 and 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. They return 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: ???

I can't predict when value stocks will recover from the current financial crises, but this data suggests that you want to be invested when they do -- because their performance will probably 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. Warren Buffett said recently that this is the time to buy. Ever curious, I used the stock screening tool on Motley Fool CAPS to search for some highly rated large-cap stocks with high dividend yields and low price-to-earnings multiples. I came up with the following list, which could be a good starting point for further research:

Data from Motley Fool CAPS, Yahoo! Finance, Google Finance, and Capital IQ, a division of Standard & Poor's.
*Aegon has announced it will omit its year-end payment in order to strengthen its capital position.

The Foolish bottom line 
The market is 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.

This article was first published Sept. 11, 2008. It has been updated.

Fool analyst Andrew Sullivan has no financial position in any of the other stocks mentioned in this article. Veolia Environnement, Diageo, and Bank of America are Motley Fool Income Investorselections The Motley Fool has a disclosure policy.