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BULLS & BEARS: Embracing unloved stocks great way to make money

April 16, 2007

Proverbs 30:19 states that there are "four things I'll never understand, how an eagle flies so high in the sky, how a snake glides over a rock, how a ship navigates the ocean, and why adolescents act the way they do."

Having had three adolescents, I will agree they are beyond understanding.

If there had been a stock market in the 10th century B.C., the author might have added one more item to the list.

Besides adolescents, he probably wouldn't have understood why adults believe the market is efficient.

Dr. Eugene Fama of the University of Chicago crafted the theory back in the 1960s, and it became the seed for the incredible blossoming of the index-fund industry.

The efficient market theory basically states that, because all of us have access to the same information about a stock, the price of the stock reflects a rational assessment of all that information.

Theorists preach that because a stock, as well as the market, is rationally and efficiently priced at its true underlying value, you can't beat 'em. So you might as well join 'em by buying an index fund. I have a hard time wrapping my mind around the basic logic of the whole efficient-market concept.

The "market" is us-people who buy and sell a couple of billion shares every day.

Why would human beings be rational about a decision to buy and sell a stock when they are irrational about many other decisions?

Purchase and sale decisions are often emotional, not rational.

The way the stock market gyrates after an event like 9/11 seems more like adolescent emotion than adult rationalization to me.

One guy who doesn't buy into all this efficient stuff is Warren Buffett.

Buffett says, "I'd be a bum on the street with a tin cup if the markets were always efficient. Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn't do any good to look at the cards."

Warren Buffett has built a pretty good career finding seriously mispriced stocks to buy.

Buffett went on to say, "It's been helpful to me to have tens of thousands [of students] turned out of business schools taught that it didn't do any good to think."

One money manager who has capitalized on pricing inefficiencies is the Leuthold Group, which for more than 30 years has screened for what it calls undervalued and unloved stocks.

Since 1975, this list of ugly ducklings has returned an annual compound of 15 percent per year vs. the market's 10 percent annual return.

The screen looks for various fundamental traits such as a price-earnings ratio under 12, a price-to-book less than two, a dividend yield above 3 percent, low debt ratios, etc. This year, 97 stocks fit the bill.

In the 30 years of buying the ugly bunch, Leuthold has had only four years when it lost money.

The concept has worked well enough that, last year, Leuthold started a mutual fund called, quite naturally, the Undervalued & Unloved Fund-which, by the way, sports the best ticker symbol in the business, UGLYX.

If you want to try to capitalize on the adolescent inefficiencies of the stock market, go ugly or go home.



Gilreath is co-owner of Indianapolis-based Sheaff Brock Investment Advisors, money management firm. Views expressed are his own. He can be reached at 705-5700 or daveg@sheaffbrock.com.
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