My 'Double Cheap' Portfolio Looks Good

These underpriced stocks have averaged 17% annual returns since 1999.

I recently back-tested a portfolio of "Double Cheap" stocks and found that they outperformed the market fairly strongly over the long term, averaging a little over 17% annually since 1999.

These are stocks that trade at low multiples to book value, as well as at low enterprise value to earnings before interest and taxes (EV/EBIT). I've written about "Double Cheap" stocks before, but haven't tested this system in a while.

To make sure I just looked at undervalued-but-solid companies that have a decent chance of recovery, I only included those than earn a Piotroski F score of 5 or more. And since this is a "cigar-butt approach," I rebalanced my "Double Cheap" portfolio every quarter to take profits on those stocks that had recovered to trade at more-reasonable valuations.

As noted above, back-testing this screen produced strong results. The portfolio's worst period was in 2015, when it would have included a lot of energy stocks that looked cheap but got a lot cheaper.

The portfolio has held 78 stocks on average over the time period I back-tested. But like so many value portfolios out there, the number of stocks that pass the screen can serve as a pretty good indicator of market conditions.

If more than 100 stocks make the list, it's time to sell all of your possessions, borrow as much money as you can and use it all to buy stocks. But when the screen turns up less than 50 names, it's time to sell your equities and take a little vacation until more value emerges.

Right now, just 38 stocks make the cut:

Of course, the small number of stocks that pass the screen isn't shocking given the seven years of rising U.S. equities prices that we've seen. (It also reinforces my caution about being fully exposed to stocks these days.)

As for what market sectors currently make up the "Double Cheap" portfolio, community banks represent the largest component -- as has been the case with virtually every value screen that I've run over the past year. Small banks account for some 30% of the portfolio's current names. One larger bank -- Comerica (CMA) -- also makes the list.

Life-insurance companies serve as the portfolio's second-largest component. I'm comfortable with portfolio members Prudential (PRU), Northwestern Life (NWLI) and Unum (UNM), but have to let my qualitative side override my "inner quant" when it comes to component American Equity Life (AEL). AEL does a lot of indexed-annuity business and will be hurt by new U.S. fiduciary regulations that change the rules for retirement plan investing.

The "Double Cheap" portfolio currently has a 78.8% average price-to-tangible-book value, 3.74 average EV/EBIT ratio and a $1.4 billion average market cap. Dividend yields average about 1.56%, while the typical F Score is about 6.0 (meaning companies in the group are fundamentally solid).

At the time of publication, Melvin was long NBN, NWLI, SVT and GWGWF, although positions may change at any time. Please note that due to factors including low market capitalization and/or insufficient public float, we consider some of the equities mentioned in this column to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.