Challenging a Cherished Belief

 | Jan 25, 2013 | 4:00 PM EST
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Thursday, I wrote about research from Robert Haugen and Nardin Baker that blows an enormous hole in one of the investment world's most cherished beliefs. We have been taught that risk equals reward in the markets and that to earn higher returns, one must take additional risks. This is not the case. Lower risk, lower volatility stocks actually outperform higher risk, more glamorous issues. The researchers found that this is because of what they call "agency issues." Everyone believes the same thing, and everyone wants higher returns. As a result, everyone owns the same high-multiple, more volatile stocks with subsequent substandard results.

I believe that unpopular stocks that trade cheaply based on asset value also outperform glamor stocks, as well as the broader market, over time. Today, let's combine these two factors to fund stocks that can beat the market over time. I ran a screen for cheap stocks with lower volatility than the broader stock market to see if I could reach any valid conclusions that might make money over the next few years.

The first impression is that the Trade of the Decade is on the right track. A very large percentage of names produced by this screen are small banks. Most of them are micro- and nano-cap banks that I expect to see taken over before long. I own a bunch of them as part of my TOD portfolio, and was I glad to see that they fit in with the research of Haugen and Baker.

Some of the larger banks that I own, and have mentioned before, also make the grade as cheap, low-risk stocks with the potential to outperform the markets. Westfield Financial (WFD) remains one of my favorite picks among banks that have undergone a mutual-to-stock conversion in the past five years. The Massachusetts bank trades at 80% of tangible book value and has excess capital to spare, with a tangible equity-to-assets ratio above 15. It has a loan-loss ratio of just 0.30%, which is among the lowest I have seen in a long time. WFD is wildly over-reserved, with a reserve-to-non-performing-loan ratio of 2.77, compared with an industry average of 0.6.

Essa Bancorp (ESSA) is also on the list of low-volatility, cheap bank stocks. The stock trades at just 90% of tangible book value and has a solid balance sheet with a tangible-equity-to-assets ratio of 11 and not-performing assets of less than 2%.

Berkshire Bancorp (BERK) is also on the list trading at 90% of tangible book value as well. It also has excess capital and very low loan losses, and the shares can be bought at the current level of about $8.19.

I was somewhat surprised that several mortgage real estate investment trusts made the list. Hatteras Financial (HTS) invests in agency mortgage-backed securities and trades at 80% of tangible-asset value. The shares yield a little over 10% at the current price of nearly $27. Institutions own less than 60% of the outstanding shares and the stock has been far less volatile than I would have expected.

The same holds true for one of my favorite mortgage REITS, ARMOUR Residential (ARR), which trades at about 90% of asset value and yields a generous 13%. Institutions own less than 40% of the company and the volatility is far less than well-known names in the sector.

The more time I spent with the list of cheap, low-volatility stocks, the more comfortable I became with the idea that Haugen and Baker were on exactly the right path for long-term investors. I am familiar with many of the stocks on the list, and I own a lot of them as well. These lower-volatility issues tend to behave very much like bunny rabbits. They can sit still for a long time until something comes along in the form of a strong earnings report, takeover, or other positive surprise. Then they are capable of moving very far very fast. Using volatility to filter cheap stocks is another way to build a margin of safety into our investment activities. Safe, cheap and boring is still the best path to exciting profits.

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