Today I want to look at the other part of the University of Michigan Tozzi Electronic Business and Finance Center's stock-picking experiment. In addition to looking for the torpedo stocks that can blow up your portfolio, they also have what they call The Value 40 Fund. Using the same academic ideas and anomalies -- like value, momentum, quality, predictability, and smart money -- they invert the process and look for stocks to buy.
The portfolio is rebalanced once a month -- and to say it has done well is something of an understatement. The Value 40 has outperformed the S&P 500 10 of the past 12 years, and has also produced positive returns in 10 of 12 years. It is a great shopping list of undervalued stocks with the potential to provide substantial long-term returns.
The list is not as full of community banks as it was last year, but there are still six trade-of-the-decade small banks in the current portfolio. Last year, the fund was 22% in small banks when the year started, and they played a significant role in the fund's 29% return in 2016. The allocation to community banks in 2017 falls to just 15% of the fund, but even after the post-Trump runup in small banks, there are still cheap stocks in the sector. The industry is in a sweet spot -- with decent loan demand, excellent credit conditions and the potential for a strengthening economy that creates wider net interest margins.
Four stocks -- or 10% of the fund -- are invested in real-estate-related securities. Two of them are homebuilders, and while Wall Street has not yet warmed up to the industry, I think it has the potential to be an excellent long-term business. Lennar (LEN) is on the list; and you may recall that was one of the stocks I talked about a week ago as being strong enough to survive for the long run and provide patient investors with great returns. The company is expanding in the active Florida markets, and has a good presence in the first time and move-up home market that is just starting to show signs of sustained improvement.
Taylor Morrison Home Corp (TMHC) has seen a big rally in its stock price over the past year, but the stock is still relatively cheap -- trading at 1.2x book value and a price to earnings of 13, right now. The F-score for the company is 8, so the prospects over the next year are pretty good. It serves a range of markets -- with communities that appeal to first-time, move-up, luxury, and 55-plus buyers. The company has operations in some of the best markets in the country -- including Florida, Georgia, Carolina, Texas, Arizona, California, and Colorado. The stock has the wind at its back, and momentum and improving industry conditions could help it move even higher.
Chimera (CIM) is also in the Value 40 fund this year. The mortgage REIT is trading at 1.1x book value and yields 11.24% right now, so you are being paid handsomely while waiting for the stock price to move higher. Chimera closed on three loan securitization deals in the second quarter of the year that had a total value of $5 billion. Management believes that these deals will provide what they call "stable and steady cash flow" for several years. If that is the case, then the dividend should be safe and may even be increased further.
The last real estate security is Forestar Group (FOR) . The company has been restructuring for much of the past year, as it unwound some of the bad decisions made in past years --including oil and gas investments at the peak of the market. In the past year, Forestar has sold $425 million in non-core assets and used the proceeds to reduce outstanding debt by over $320 million. Once all the non-core assets are sold, SG&A expenses should decline by about $50 million annually. That's about $1.53 a share, which is about three times the trailing 12-month earnings. If the company can get a significant amount of the savings down to the bottom line, the stock should see dramatic long-term returns.
The Value 40 fund has a long record of outperformance -- and this year's collection of stocks is an interesting mix that has the potential to do well in 2017. In addition to the banking and real estate stocks, they have auto parts suppliers, racetracks, insurance companies, airlines, business development companies and floating rate funds that should help drive performance. It is an interesting mix of businesses worth further investigation.
