We can debate endlessly whether stock markets will soar or shrivel in 2012. But value investors are interested in a simpler and potentially more profitable question. They want to know if value stocks are sufficiently cheap to satisfy their inner miser.
One way to answer that question is by turning to the work of Dartmouth Professor Kenneth French, who publishes data on U.S. stocks that goes back to 1926. He uses price-to-book-value ratios (P/B) as a predictor of a stock’s future success.
In one study, he sorted stocks by P/B, split the market into fifths, tracked the performance of the five groups for a year, and then repeated the process. You can think of the lowest-P/B slice as the value-stock group because that’s where you can buy the most book value for the lowest cost – usually because investors have fallen out of love with these stocks and driven down their prices.
Despite their lowly status, this cluster of beaten-up stocks has been the place to be over the long haul. The value group has generated 19.2 per cent average annual returns from July 1926 to July 2011, well above the returns of any other group. History’s lesson is clear: buying stocks with low P/B ratios produces strong returns. Expectations are so low for these stocks that even a little good news is often enough to propel their prices upward.
Investors should keep in mind, though, that the line that divides the value stock group from other stocks changes each year, as markets move up and down. Prof. French calls this line a breakpoint and it provides an interesting gauge of how cheap value stocks are in any given year compared to their historical norms.
The accompanying graph shows how the value breakpoint has changed over time. (The figures are based upon Prof. French’s research, except for the last data point, which represents my estimate of its current level.) The graph also shows the average breakpoint for the full period and the current breakpoint.
Over the past several decades, the value breakpoint has averaged 0.72 – stocks that have a P/B below 0.72 have fallen into the value group; those with a P/B above this level have not. As it happens, that’s quite close to an old value investing rule of thumb that suggests investors buy stocks only when they trade below 66 per cent of their book value.
Unfortunately, there aren’t many stocks that pass such a stringent test this year. Indeed, the value breakpoint now sits at a P/B of 1. That’s not the highest it’s been in recent times but it is well above average, which suggests that value investors should be cautious.
This doesn’t mean that you should rush out to dump all your value stocks. But, as the new year begins, it suggests that investors may want to keep a little extra cash on hand.