The concept of value investing is very simple; buy assets for less than they are worth. The larger the discrepancy between price and value, the bigger the margin of safety. Intuitively, value investing makes sense. Not only does it make sense, it creates high returns.
Numerous studies have shown that buying assets for less than they are worth creates excess returns. The image below shows the performance of an equal weighted portfolio of the value decile (10% of stocks with lowest P/B) of stocks compared to the glamour decile (10% of stocks with highest P/B). A 20% CAGR over the period from 1926 to 2013 is nothing short of amazing.
Don’t Get Too Excited – Value Stocks Are Scary
Value investing is simple, but not easy. Stocks trading at a discount to their assets usually do so for a reason; because there are serious problems or questions about the business’ future. Many of the cheapest stocks are minimally covered by Wall Street. They tend to have small market caps and little trading volume. A typical deep value stock will have a low market cap and small daily volume. The company will be largely unknown, overlooked, and come with serious questions abou its future.
What stocks make up the value decile in the US today? There are 3,844 US stocks with P/B information available on Finviz. The value decile is composed of the 384 stocks with the lowest P/B value. The most well known companies in the value decile today are:
- Bank of America (BAC) – 0.73 P/B
- Citigroup (C) – 0.75 P/B
- American International Group (AIG) – 0.73 P/B
- Sprint Corporation (S) – 0.86 P/B
The companies above should not jump off the page and scream high quality businesses. Individual value stocks tend to be riskier than average. Not only are they riskier, they are also smaller. The median market cap of the value decile today is about $98 million. This is extremely small; keep in mind most small cap funds invest in stocks with market caps over $300 million.
Together We Are Strong
Individually, value stocks are highly risky. We can’t know beforehand which stocks will appreciate and return to fair value, and which stocks will see their businesses deteriorate. Value investing generates enormous returns on the whole, but which stocks will generate those returns is difficult to determine.
Can you really make money in them [stocks] without taking a serious risk? Yes indeed if you can find enough of them to make a diversified group, and if you don’t lose patience if they fail to advance soon after you buy them.
- Benjamin Graham, father of value investing
Unfortunately, undervalued stocks do not rebound when you buy them. Some may rebound to fair value in a month, others may take years, or may never rebound at all. Waiting for your dividend stocks to appreciate can be nerve racking. What if there were a way to generate strong returns while you waited for value stocks to appreciate?
High Dividend Yields & Low Asset Values
Combining classic value investing with stocks that have high dividend yields provides psychological benefits. Instead of waiting for a stock to appreciate, you are paid to hold the stock. If it takes several years to recover, you will have created cash flows from the dividends on the stock. If the business recovers quickly, then you have a high CAGR resulting from capital appreciation. In this fashion, you protect yourself from mediocre returns from stocks that take multiple years to recover to fair value.
The 10 stocks with the highest dividend yields in the value decile are listed below. Companies that are investment trusts or limited partnerships were not included. Only ‘real businesses’ are below.
UPDATE: Roundy’s no longer pays a dividend. The rest of the stocks on the list currently pay dividends.
All of the above businesses have P/B ratios well below 1, and have high dividend yields. Roundy’s is a struggling grocery chain that will likely reduce or eliminate its dividend in the near future. Quad graphics is in the decidedly unpopular printing industry. There are several local banks on the list as well that could be potential takeover targets for larger corporations. Clearly, these are not the type of companies that are suitable for long-term investment. Rather, they are ‘cigar butt’ stocks.
If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.
- Warren Buffett
The above list is a starting place for investors looking to build a portfolio of undervalued securities that pay you to wait for the to appreciate to fair value. Diversification of such a portfolio is key. One should hold at least 20 stocks to take advantage of the value effect while maintaining limited exposure to individual undervalued securities.