Value hunter: Beating the bushes for mini-bears

In trying times like these, it’s easy to wonder: are stocks headed for the abyss or will they turn around and shoot sky high? Frankly I don’t know. But if pressed, I’d say the markets are currently on the high side of fair value. They’re not wildly expensive, like they were in 2000. Nor are they cheap, because valuations are still above historical norms. As a result, I’d say we’re due for modest long-term gains but the ride could well be a wild one. Much higher, or lower, levels are certainly possible in the short-term.

I find the markets to be at their most interesting when prices are down and the fear is palpable. After all, when the whole market sells off, you can usually snap up good companies at very low prices. But such market-wide opportunities don’t materialize every day. Instead, you’re more likely to see particular industries, or individual companies, suffering from their own mini-bear markets.

To find these potentially profitable situations, I like to use two simple measures Benjamin Graham suggests in his classic book The Intelligent Investor. First, I like stocks trading at low price-to-earnings ratios (P/E), because they offer large streams of income at a low price. Second, I like stocks with low price-to-book-value ratios (P/B), because they offer investors heaps of assets at a great big discount.

Of course, such low ratios can indicate that the market is worried about the company’s health—and sometimes the market is right. So it is wise to examine the source of the concern carefully. But investors often get far too depressed about the near-term outlook and discount a longer-term revival. For instance, it was only a few years ago when you could buy all of Apple (NASDAQ:AAPL) for about the amount of cash it had in the bank at a low P/B ratio. Now, just a few years later, an avalanche of gains has helped push Apple’s market value above even Microsoft’s (NASDAQ:MSFT).

Indeed, Stephen Penman and Francesco Reggiani recently published a paper, Returns to Buying Earnings and Book Value, which looks at how an investor would have made out with a combined low-P/E and low-P/B strategy between 1963 to 2006. It turns out he would have reaped an astounding average annual return that was a full 13.4 percentage points higher than the return on the average stock. That eye-popping figure helped to inspire my value investing technique this month.

My version of their low-P/E and low-P/B strategy starts with the 500 U.S. stocks in the S&P 500. I then apply a two-fold sort. First I sort the stocks by P/E, and keep those with the lowest 20% of positive ratios. This shortlist of stocks is then sorted by P/B, and only those with the lowest 20% of positive ratios are kept. That left me with 20 value candidates. The full list, along with a variety of facts and figures for each stock, see page 2 of this story, but I’ll highlight three with particularly low ratios here.

The first and perhaps most interesting candidate is Loews (NYSE:L, $31.39), a large holding company run by the Tisch family. Loews happens to own three publicly traded companies. It controls 90% of CNA Financial (NYSE:CNA), 50.4% of Diamond Offshore Drilling (NYSE:DO), and 66% of Boardwalk Pipeline Partners (NYSE:BWP). Loews also owns all of HighMount Exploration & Production, a natural gas firm, and Loews Hotels. But I didn’t just list Loews’ properties for fun. You see, if you simply add up the market value of its stake in the publicly traded firms, you come to a sum that exceeds Loews’ own market value. Even better, the stock trades at 75% of book value and at 8.3 times earnings, quite low considering the company has more than doubled its book value over the last 10 years. Loews has also traded at a healthy premium to book value in the recent past—so investors stand to make a pretty penny should Loews merely regain its past highs.

Ameren (NYSE:AEE, $23.96) is an electric and natural gas utility based in St. Louis, Mo., which also has operations in Illinois. The firm pays a generous 6.4% dividend yield, and it trades at 9.3 times earnings and at 72% of book value—a bargain based on the numbers. But the low price is at least partly due to the firm’s decision to cut its dividend last year, which indicates the utility ran into trouble. Mind you, the current dividend rate seems sustainable, because it represents only 60% of earnings.

Rowan Companies (RDC, $23.32) is a contract-drilling firm with global operations. While it works on land, it also focuses on hard-to-drill deep offshore gas wells. As you might imagine, the BP disaster in the Gulf of Mexico has not only torpedoed BP’s stock but it has hurt the offshore drilling industry too. You can bet that the regulators will be taking a hard look at future offshore projects but, the harsh reality is, they’re necessary. Even in the unlikely event that they’re permanently stopped in the U.S., other countries will take up the slack. If you don’t mind a little political uncertainty, Rowan is an interesting candidate. It trades at only 8.8 times earnings and 84% of book value.

Be aware that when you’re bottom fishing, you’re not always going to find treasure. Sometimes the market’s worries are realized. As a result, it’s best to go for the shotgun approach, and build up a diversified portfolio of value stocks to avoid being hurt should one or two fail. If you need more value picks to round out your portfolio, click here.

Full list of stock picks