Lowest of the Low-P/E Firms Post Big Outperformance

Numerous contrarian investment strategies have a track record of solid performance. But just how well — or poorly — do the most unloved stocks in the market fare?

According to columnist and money manager John Dorfman, they have fared quite well in the past dozen years. In his Bloomberg column, Dorfman takes a  look at a virtual portfolio that, starting in 1999, would have invested in the 10 stocks with the lowest price/earnings ratios in the market, rebalancing once a year. His findings: From 1999 through 2010, the low-P/E portfolio averaged annual compound returns of 16%, vs. 1.5% for the S&P 500.

Dorfman notes that these very low-P/E stocks tend to come from companies that have well-known problems, and are high-risk plays. He thus limited his virtual portfolio to stocks with market capitalizations of at least $500 million and with less debt than equity to try to mitigate some of the risk. (In addition, while he does not specify, Dorfman appears to be using past earnings in his P/E calculations, not projected earnings. And since a low-P/E firm must, by definition, have a P/E ratio, the stocks in his portfolio therefore must have positive recent earnings. That eliminates firms that have been losing money.)

“The rationale behind low P-E investing is that stocks advance by exceeding investors’ prevailing expectations,” he notes. “Low expectations are easier to exceed. Thus, paradoxically, unglamorous stocks with well-known problems often outperform glamorous issues that are popular with investors.”

Dorfman also takes a look at the 10 low-P/E stocks that are in the portfolio for 2011. Among them: Internet service provider Earthlink Inc., industrial vehicle maker Oshkosh Corp., and Ariad Pharmaceuticals, which makes drugs that fight aggressive forms of cancer.

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