Tweedy, Browne’s booklet, “What Has Worked in Investing” is a summary of more than 50 academic studies relating to, well, what has worked in investing.
The primary conclusion of their analysis? Attractive returns are the result of buying cheap stocks.
A very basic way of testing the “cheapness” of a stock is to compare its price to its book value (the value of the company’s net assets). Dartmouth College professor Kenneth French has compiled return data for available stocks traded on US exchanges since 1926 and has grouped them based on several factors, including book value.
Using Dr. French’s data, we charted the rolling 10-year returns for the cheapest stocks (the lowest 30% of stocks measured by price-to-book) versus the most expensive (the top 30% of stocks):
In about 87% of the observed 10-year periods, the cheap stocks outperformed the expensive stocks. The average amount of outperformance was about 4% per year.
The key takeaway from this research is that Price Matters. In stark contrast, market-cap weighted indexes (the S&P 500 for example) do not differentiate between cheap and expensive stocks. Their only criterion is the relative size of the company. We believe there is compelling evidence that it pays to be discriminating about price.
Aaron Pettersen, CFA, CFP®