Value Stocks Have Been Modest Outperformers

After growth stocks, and more specifically, the four horsemen of technology outperformed the market during 2007, some well regarded advisors think that 2008 may be the year for value stocks. In fact, one popular value investor thinks that at current levels, value stocks are trading at one of their steepest discounts to the overall market since 1970.

Richard Pzena runs Pzena Investment Management (PZN), and in his fourth quarter newsletter, he highlights that the only other times where value stocks were cheaper than they currently are was in November 1999 (Internet Bubble), June 1973 (Bear Market/Nifty Fifty), and October 1990 (S&L and Real Estate Crisis). In his example, Pzena classified value by looking at 100 stocks in the S&P 500 with the lowest price to book ratios. On a side note, it's somewhat ironic that according to Bloomberg, Pzena's publicly traded company trades at a price to book ratio of 101.91, which is 38 times the level of the S&P 500!

While many investors often measure a stock's value based on its P/E ratio, Pzena's use of book value is hardly out of the norm. In his book What Works on Wall Street, James O' Shaughnessy devotes an entire chapter to measuring the performance of stocks based on their book values. He points out that many investors believe it is "a more important ratio than price-to-earnings...since earnings can be easily manipulated by a clever chief financial officer." O'Shaughnessy's conclusion is that, "Over the long-term, the market rewards stocks with low price-to-book ratios and punishes those with high ones."

With Pzena's and O'Shaughnessy's findings in mind, we screened the S&P 500 for the 100 stocks with the lowest price-to-book ratios. However, given the recent writedowns in the financial sector, we wanted to avoid names that looked cheap but may face further writedowns in the coming quarters. For example, Ambac (ABK) and MBIA (MBI) both have some of the lowest price-to-book ratios in the S&P 500 (0.59 and 0.55, respectively), but over the last year ABK's book value has declined by 62% while MBI's has declined by 45%. In order to avoid these companies whose book values have been falling by almost as fast as their earnings, we further screened the list for companies whose book values have increased by at least 10% over the last year.

While the names in the above list may not be the sexiest stocks in the S&P 500, we would note that while the S&P 500 has had a total return of negative 9.5% year to date, the twenty names on the above list have outperformed, declining by 6.2%.