In July 2008, I contacted an old friend, Henry Carstens of Vertical Solutions, to test a few ideas. He's written many papers on testing and developing approaches to trading and investing, and we once worked together on a project that was a lot of fun. We tested buying stocks on the S&P 500 that had low levels of debt and traded below book value. We found that this approach handily beat the market during a 12-year period from 1995 to 2007.
Let's see how this approach has fared in the three years or so since we ran that test. The S&P 500 was slightly higher than it is now, at roughly 1250 the week we published the results. The market today is right at 1180, so it is down more than 4% since then. The portfolio of stocks, including dividends, has returned about 5% over the same period, so it has beaten the market. It was a wild ride, though, and for the balance of 2008 and first half of 2009, the portfolio had a huge drawdown as the market collapsed. It took some fortitude to stay in while the portfolio dropped by almost half over that period.
I ran that screen today to see what stock might fit the criteria three years later. Two stocks immediately made the list again as their shares have not done much over the past few years.
Cincinnati Financial (CINF) rallied to about $33 earlier this year but has since pulled back along with the broader market. The property-and-casualty insurer is never going to be the most exciting stock in the marketplace, but is trading at 90% of tangible book value and pays a generous dividend. At the current quote, the shares yield 5.99%. The company continues to be hampered by a very soft market for property-and-casualty-insurance premiums. As the economy improves, that market should firm up again and help Cincinnati Financial grow its bottom line. In addition, heavy catastrophe losses should drain excess underwriting capacity from the marketplace and that could lead to firmer insurance pricing.
Tellabs (TLAB) is also a repeat on the list of cheap stocks in the S&P 500. Although the stock has not done much for investors since 2008, there has been a chance to make a tidy sum trading it. Buying the stock below $4 and selling it above $7 has worked very well over the past three years. With the stock trading around $3.90 today, aggressive investors might want to accumulate the stock for a six- to 12-month trade. The stock trades at 90% of tangible book value and the company has $3.36 per share in cash on the books. Business has not been stellar for the communication equipment and systems company, but the stock is cheap.
One of my favorite stocks, Micron Technology (MU), is also on the list. Concerns about weak chip sales to the PC market have put enormous pressure on Micron shares, however, the company's exposure to the PC market is down to 30% of revenues and still falling. Demand for its chips used in mobile computing products should see strong demand, thus, consumer demand for notebooks, smartphones and tablet computers should drive chip sales. Earnings will climb rapidly as demand grows. At 70% of tangible book value and trading at a discount to my calculation of liquidation value, Micron is too cheap not to own.
Two insurance companies round out the list of cheap S&P 500 stocks. Both Assurant (AIZ) and Principal Financial Group (PFG) have sound balance sheets and trade below tangible book value. The portfolio is a little overweight insurance stocks, so you might want to pick your favorite. For me it's Cincinnati Financial at this price; Principal is more weighted towards asset management and life insurance, so I would include that stock as well.
This approach works over time. And keep in mind that these stocks are on a heavily traded index. The activities of traders in the leveraged funds and high-frequency black boxes will affect their stock prices. Make that work for you: buy on big down days and sit still when the market rises sharply.