Over the weekend, while watching the Orioles win yet another series on their way to an American League title, I spent some time with a new e-book called Quantitative Value Investing in Europe: What Works for Achieving Alpha, by Phillip Vanstraceele and Tim du Toit. I haven't finished it yet, but the authors have some excellent data points and information. They looked at a bunch of fundamental factors to see which produced the best returns in European markets between June 1999 and June 2011.
Of all the factors considered during the time period, the best factor was, to my delight, price to book value Buying stocks below book value earned a compounded annual return of 10.92%, compared with just 2.25% in the Euro Index. The second-best variable was another favorite, price to free cash flow, which produced a 10.87% compound return. It is amazing to me that no matter how much evidence piles up in favor of the value approach, most investors still prefer the hot and popular momentum ("mo-mo") stocks.
Where the study really gets interesting is when the authors combine low price to book value with six-month relative strength. Limiting your portfolio to stocks under book value that have the best six-month performance produces an annual return of 23.5%, or about 10 times the return of the market index. What worked in the past doesn't always work in the future, but there is plenty of evidence from academia and the real world to suggest that value and momentum work well together. Given the strength results in this study, I sat down this morning and looked for cheap stocks in Europe that have the best six-month strength, to see if I could spot any likely candidates right now.
Shares of U.K.-based Eros International (EROS) have been on a tear this year but still trade at a slight discount to book value. Although the company is based in the U.K., the company does most of its business in India, which is one of the faster-growing economies in the world. Eros acquires, co-produces and distributes Indian films. The company also has a huge library of 2,300 films and holds digital rights for about 700 additional films. As a new government in India helps create a larger middle class that wants entertainment options, this company could do very well for an extended period of time.
Veolia Environnement (VE) provides a range of environmental services in the fields of water, waste and energy management. The company collects and processes trash, provides drinking water and fixes air-conditioning systems in France. It also has road and rail systems in the economically troubled nation. Although the French economy is dragging, people still will produce trash and need water and transportation, so this company should hold up better than the average French business. The shares trade at just 84% of book value and have been up in the past six months. The company may also benefit from the growing biofuels market, as its 200 wastewater facilities in North America could be used to produce biomethane. The stock provided a dividend yield of over 5%, so this stock has decent cash flow as well as appreciation potential.
XL Group (XL) is an Irish insurance company that has been posting solid results this year. It earned far more than analysts expected in the latest quarter as its underwriting profits almost doubled. The company sold its reinsurance business last month in order to focus on its core operations, and it plans to use the $570 million in proceeds to buy back additional stock. Management is pretty shareholder-friendly, as it plans to buy back as much as $300 million of stock this year, and it just raised the dividend by 14%. The shares currently trade at 86% of book value.
I have no idea what the European market will do over the rest of the year. The recovery has been a slow, grinding affair, and the Continent could easily slip back into a recession. These three stocks are cheap, they have been performing well in the past six months, and they could continue to do so, no matter how the broader markets in Europe perform.