Want Outsized Profits? Think Garage Sale

08/02/2011 1:30 pm EST

Focus: GLOBAL

Low P/E stocks have outperformed over the long term, and you may even get a gem or two, writes Norman Rothery for The Globe and Mail.

Fling open your closets and clear out your basement because it’s garage sale time. If all goes well, you might be able to shift the contents down the street. In my neighborhood, you also get the chance to buy sugary pools in flaky cups from the friendly butter-tart lady.

But the humble garage sale yields more than sugar-rush-inducing treats. It can offer lessons for stock investors.

Importantly, garage sales are filled with motivated sellers. Perhaps they need room for new things. Perhaps they’ve lost weight and no longer need a score of diet books. But, by the end of the day, they’re hoping to be rid of some stuff.

A really savvy buyer might find a hidden treasure at a garage sale worthy of an appearance on Antiques Roadshow. But more commonly you’ll find an everyday item at a bargain price.

That’s exactly the sort of approach you should take when looking for stocks. Buy dull firms at good prices and perhaps get a gem or two.

But how do you find the bargains? For the answer, look to value investing, which can be a surprisingly simple way to earn outsized profits.

While value investing comes in many different flavors, it usually starts with ratios, because value investors like to compare a company’s price to some fundamental measure of financial merit.

Let’s consider the popular low price-to-earnings (P/E) approach. Intuitively, buying stocks with low-P/E ratios makes sense. After all, you get lots of earnings at a low price, which sounds pretty good. Even better, low-P/E stocks have outperformed, as a group, over the long run.

For proof, I turn to Dartmouth professor Kenneth French’s data on US stocks, which starts in 1951 and goes to the end of 2010. He begins by sorting the universe of US stocks by P/E from high to low. The list is then divided into ten portfolios, with the 10% of stocks with the highest P/Es placed in portfolio ten, the next 10% down in portfolio nine, all the way to the 10% with the lowest P/Es in portfolio one.

Each year the portfolios are sold, and the stocks sorted again. The effort is worth the trouble—just take a look at the returns for each portfolio in the accompanying table.

The average gain for the low-P/E group was an astounding 20% a year, whereas the high-P/E group only climbed 9.3% a year from 1952 through 2010. In addition, low-P/E stocks were winners when the results are broken down by decade.

While the evidence for low-P/E investing is strong, the method is not a panacea. It does run into periods, sometimes lengthy, of relative underperformance.

For instance, 2010 wasn’t great, relatively speaking, for value, because high-P/E stocks led the way. The Internet bubble of the late 1990s was also, temporarily, a hard time for value stocks compared to the darlings of the period.

NEXT: My Value Recommendations

|pagebreak|

Nonetheless, over the very long term, value has been a winning approach.

Based on the historical record, you might want to rush out to do due diligence on a slew of low-P/E stocks and I wouldn’t blame you. But many investors want to take a more hands-off approach, and they prefer to invest in mutual funds and exchange-traded funds.

On the fund front, it only seems appropriate to start with Dimensional Fund Advisors, which manages money based on Prof. French’s work. In Canada, DFA’s new Vector equity funds are particularly interesting, because they focus on small value stocks.

Unfortunately you can only buy them with a side order of advice, but even then the overall cost remains relatively modest at 1.3% a year for the Canadian version of the fund.

An honorable mention should also go to RBC’s O'Shaughnessy series of funds, which similarly follow quantitative approaches. Their US Value fund focuses on dividends instead of earnings, but it has bested the markets nicely over the last ten years. It also sports a relatively low 1.5% management expense ratio.

One might also explore the brave new world of value ETFs, which seems to expand on an almost daily basis. In the US, the Rydex S&P Pure Value series of ETFs (symbols RPV, RFV, and RZV), which cost 0.35% a year, are interesting options, because they track value in the S&P 500, S&P Mid Cap 400, and S&P Small Cap 600.

If you want a human touch and an actual value guru to guide your portfolio, then Francis Chou is your man, and his Associates fund (1.79% MER) is a good way to go. Francis runs a deep-value investment firm and has a long history of trouncing the markets.

Take some wisdom from garage sales and improve your returns by buying value stocks. As an added bonus, your portfolio is unlikely to suffer a sugar-induced crash from tarted-up concept stocks.

Related Articles on GLOBAL