Investigating a Modifed Value Approach

 | Apr 09, 2013 | 12:30 PM EDT
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To longtime readers of Real Money, my base approach to the markets is pretty well known to all by now. However, I am constantly investigating, testing and evaluating other approaches. Most are modifications and variations on a value theme, as I am intellectually incapable of abandoning my value beliefs and vulture tendencies.

I have no intention of missing a baseball game or my afternoon nap in order to stay glued to a  screen trading all day. I am also just not capable of paying of paying enormous multiples for hopes and dreams the way that many growth and momentum investors do on a regular basis. Almost all of my research involves buying core stocks that are beaten down or buying cheap assets.

Lately, I have been investigating buying stocks that trade for less than 90% of book value and have a reasonable capital structure. Most back testing uses the idea of holding over various time periods and reformatting the portfolio. In this case, I have adjusted the approach to sell based on the variable itself. The stocks in the system are sold when the price crosses above book value or debt levels exceed certain thresholds. If book value grows faster than the price, you will hold the stock for a long period of time. If the price pops above book in a month or two, then you will sell the stock right away.

I began thinking about this approach after watching stocks such as Kimball International (KBALB) trade form a deep discount to book value, run up over book value and then sell off once again to a discounted price. Some stocks continually improve and you get a long run as the book value grows. However, others trade between cheap and fairly valued on a regular basis and selling based on variables rather than time helps catch these profits. It has a combination of long-term core holdings and shorter-term profit-taking based on fundamentals that might allow us to catch the best of both worlds.

It helps to spend some time looking at the stocks that currently qualify for this approach. The first is one that I have applied my brilliant overrides to over the past two years and it has cost me money. Genworth Financial (GNW) is an insurance and financial services firm that has been struggling back from the depths of near failure. The stock has done well. With the shares trading at just 30% of tangible book value, it is still the cheapest stock in the system.

The mortgage insurance unit that caused most of the problems is now fueling the recovery of Genworth and has now been organized as a unit under the broader corporate umbrella. The company plans to sell the Australian mortgage unit later this year in an IPO; it is also selling the wealth management business. Management will use the proceeds from both deals to reduce debt. The life insurance and long-term care businesses will recover at a slow rate (as it takes time for the economy to fully recover), but the company as a whole should see decent earnings growth this year and next. The stock has to triple to hit book value and will be a huge winner if it reaches that level over the next few years.

I haven't purchased shares of Hutchinson Technology (HTCH) in the past couple of years either, and the stock has performed well since the company posted a better-than-expected earnings report late last year. In spite of the price improvement, the stock is still the second cheapest stock in our systems portfolio – it is trading at just 50% of tangible book value. This leading manufacturer of suspension assemblies for hard drives is slowly recovering along with the computer business. The company will probably continue to report losses for the next few quarters but it could see a significant recovery as storage demand is going to increase at a strong pace. Plus, the PC business will eventually see pent-up demand hit the marketplace.

These are the two cheapest stocks in the system. On Tuesday, I will look at some of the other super cheap stocks my investigation turned up. The quick-and-dirty back tests of this approach show a long-term return substantially better than the market and more than 10x the market's feeble returns over the past decade.

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