By definition value investors are always on the lookout for cheap stocks, but as anyone who's fallen into a value trap knows all too well, sometimes a stock is cheap for a reason. A stock can trade at a deep discount to its forward or trailing earnings, sales, book value or what have you, lending it all the appearance of a bargain, but still languish or underperform the broader market for years. Or decades.
There's no magic formula for separating the true value plays from the duds, but one element to consider is a stock's so-called quality. A portfolio of cheap, high-quality stocks should, theoretically, provide superior returns over long periods of time and a common way to measure quality is by looking at a company's return on equity (ROE).
ROE describes the amount of net income a company generates as a percentage of shareholders' equity stake in the business. Essentially, it shows how adept management is at generating a return on the cash investors have put into business (as opposed to cash the company has borrowed from creditors).
So, for example, a company with an ROE of 20% means management has created $20 worth of assets for every $100 originally invested in the business. As a general rule of thumb companies with solid returns on equity, say 15% to 20%, do well by their shareholders. They generate enough cash to fund operations while also returning some of it in the form of dividends or share buybacks.
Looking for companies with large market caps and high ROEs trading at a discount to their own price-earnings (P/E) multiples is a good starting point in sussing out stable defensive investments that will provide market beating returns over the long haul. Using data from Thomson Reuters and Capital IQ, we screened for stocks with market caps of at least $10 billion and five-year average ROEs of at least 40%. Additionally, the shares had to be trading at a discount of at least 10% to their own five-year average forward P/E and have a 10-year total return greater than that of the S&P 500 ($INX) (which has essentially been dead money).
That left us with nine names. See the chart below.
Interestingly, the top three spots for five-year average ROE are held by noncyclical consumer stocks Colgate-Palmolive (CL), Avon Products (AVP) and Campbell Soup (CPB). These companies' share prices have all had their ups and downs over the years as they've tangled with higher input costs, migration of consumers to cheaper store brands or price pressure on the part of their retail partners, among other challenges. In addition to producing high returns on the money investors have contributed to their respective capital structures, they've creamed the broader market over the last decade.
True, Freeport-McMoran (FSX) has benefited from record-high prices for copper and gold, while Millicom (MICC) has gone gangbusters from in emerging markets in both hemispheres, but high ROEs still bode well for shareholders going forward.
Still, perhaps the biggest takeaway from these names is the importance of dividends. Microsoft (MSFT), the ninth name on our list, has seen its share price rise just 18% in 10 years, but add in the dividends and shareholders actually got a 47% return on their investments.