If you're going to be a cheapskate, be patient

John Dorfman
| Tuesday, April 23, 2013, 12:01 a.m.

Inspired by a paper written by my mentor, David Dreman, I wrote five columns in 2002-2006 about the “Cheapskate Portfolio.”

This hypothetical portfolio contains the cheapest stock, measured by price/earnings ratio (P/E), in each of the 10 sectors of the Standard & Poor's 500 Index. The price/earnings ratio is a stock's price divided by the past four quarters' earnings per share. Most stocks generally have a ratio of about 15; a ratio of 10 or less is considered cheap.

To be eligible for inclusion in this theoretical portfolio, a stock must have positive earnings (otherwise the ratio can't be struck). And it must have debt less than stockholders' equity, because I believe excessive debt can be poisonous to returns.

I set the criteria, but the individual stocks are not picked by judgment; they are simply the lowest P/E qualifying stocks.

The one-year results were fine, but a bit like kissing your sister: an average total return of 10.1 percent, versus 8.8 percent for the Standard & Poor's 500 Index. But the three year results (through April 2009, for the last of the five columns) were much more exciting: an average return of 32.1 percent compared with 20 percent for the S&P.

What this suggests is that if you are going to go against the crowd and buy cheap, unpopular stocks, you need to give them some time to come back into favor. And time is something few people these days are willing to give. For many people today, short-term means this week, and long-term means next month.

In five outings, my Cheapskate stocks were profitable four times and beat the S&P 500 three times. Coincidentally, those tallies were true both for one-year returns and three-year returns.

Bear in mind that results of my column recommendations are theoretical and don't reflect trading costs or taxes. Past performance doesn't predict future results. And the performance of my column recommendations shouldn't be confused with the returns on portfolios I run for clients.

Today I want to revisit the Cheapskate Portfolio concept and highlight the 10 stocks that pop up on this paradigm now. I'll report on one-year results next April, and three-year results in April 2016.

The paradigm selects Apollo Group Inc. (APOL), the for-profit college company that runs the University of Phoenix chain, as the cheapest stock in the consumer discretionary sector. Its P/E is five. Apollo and its rivals are having multiple tussles with regulators now, so I hesitate to buy the stock. Yet if the problems are resolved, the profit potential is huge.

In the consumer staples sector, there are no extremely cheap stocks. The closest is Tyson Foods Inc. (TSN), whose prepared chicken, pork and beef dishes are popular at supermarkets. The stock, at 12 times earnings looks attractive to me.

In energy, the ultra-cheap pick is Valero Inc. (VLO), a refiner. I expect gasoline consumption to increase in the United States and think Valero is a good pick at eight times earnings.

MetLife Inc. (MET) has the lowest P/E among qualifying financial stocks, just under seven times earnings. Investors, including myself, worry that interest rates will rise, causing bond prices to fall. Met, like most insurers, has a big bond portfolio.

The cheapie in the health care segment is Wellpoint Inc., a health maintenance organization that fetches only nine times earnings.

In the industrial sector, Joy Global Inc. (JOY) stands out with a P/E below eight. China's economy has slowed to a degree and that hurts worldwide sales for makers of mining equipment, such as Joy.

In information technology, disk drive maker Seagate Technology PLC (STX) is the cheapskate choice. It sells for less than five times earnings. I think investors are excessively gloomy on disk-drive makers (I own a competitor, Western Digital Corp.)

Among materials stocks, CF Industries Holdings Inc. (CF) is the least expensive in the pack, at six times earnings.

In the telecom space, because of my debt limit, there is only one qualifying stock, AT&T Inc. (T). It sells for 16 times earnings. I own it for a few clients.

Exelon Corp. (EXC), a Chicago-based utility company with a lot of nuclear plants, is the cheapest in the utility segment, at 14 times earnings. I like the 5.7 percent dividend yield and I like the company, but I consider 14 times earnings on the steep side for a utility.

All of these stocks have problems, or they wouldn't be on this list. However, I feel reasonably comfortable for the prospects for most of them. As a group, I think they will outperform the market during the next three years.

John Dorfman is chairman of Thunderstorm Capital in Boston and a syndicated columnist; jdorfman@thunderstormcapital.com.

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