I'll bet dollars to doughnuts you've never heard of Lakonishok, Shleifer, and Vishny, unless you're a total investing dweeb like me. But before they founded LSV Asset Management, which now has $51 billion under management, they were obscure academics about to publish a very famous paper. Best of all, the insights they discovered can help you find stocks that will stack the odds of a successful investment in your favor.
Turning investing upside-down
In 1994, the trio divided stocks into 10 buckets, according to earnings yield -- E/P, or the inverse of the price-to-earnings ratio, because academics prefer the exotic. LSV found that high-E/P stocks -- also known as low P/E stocks, or value stocks -- beat low-E/P, high P/E glamour stocks by 4 percentage points per year.
LSV next divided stocks into groups using a formula based on sales growth. Amazingly, it found that boring businesses with low sales growth outperformed flashy high-growth companies by 7.3 percentage points per year.
Best of all, LSV found that a portfolio combining the high-E/P and low-sales-growth approaches outperformed its opposite -- high-P/E, high-growth stocks -- by 11 percentage points per year!
I keep LSV's formula in mind every month when I'm selecting stocks for my Income Investor newsletter. Let's use it right now to dig up some slow, cheap, and potentially outperforming value stocks for your own consideration. I used data from Capital IQ (a unit of Standard & Poor's) to unearth companies trading at a P/E less than 7, with sales growth of less than 3% last year. Here's what I came up with.
Result No. 1: Noble
With a P/E of 5.7 (or an E/P of 17.5%) and a 5% decline in sales last year, this offshore oil driller for hire might make LSV proud. Recent earnings missed Wall Street estimates, and the Gulf of Mexico oil spill and resultant Obama moratorium have taken their toll on this already-volatile industry. But Noble has earned a reputation for being a solid operator, the Gulf is recovering more quickly than expected, and the company does much of its business in other regions.
Result No. 2: WellPoint
The nation's largest health insurer, which operates Blue Cross/Blue Shield insurance in a number of states, sports a lowly 4.5 P/E and flat sales growth. Why so blue? The market has pounded the stock amid fears that health-care reform will crimp earnings. But with expectations on the floor, even the smallest accomplishments could help the company surprise investors.
Result No. 3: Transocean
Another beaten-down driller, Transocean has a meager 6 P/E and a sales decline of 14% in the past 12 months. In fact, it's even closer to the epicenter of the Deepwater Horizon disaster than Noble, because it actually owned the rig that was leased to BP
Result No. 4: CIT Group
Delivering another sub-5 P/E, this commercial lender got involved in subprime and ended up declaring bankruptcy during the financial crisis. Now headed by former Merrill Lynch CEO John Thain, CIT has repaid or refinanced about 60% of its first-lien debt, and it may be on the road to gradual recovery.
See a theme here? If you scan the news articles on value stocks, you'll see plenty of reasons not to invest. But according to LSV's findings, those same reasons have already driven many investors away from stocks like these. Thus, a company facing headwinds can get priced so cheaply that it actually becomes a good investment. Things don't have to go exactly right; they just have to turn out better than the market expects. In short, companies with low expectations can give you the best chance to score a truly great investment.