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April, 2007


In its recent issue (April, 2007) of "The AAII Journal," the American Association of Individual Investors publication points out that over the past ten years its "Model Shadow Stock Portfolio" has come out #1 over the many investment advisory newsletter portfolios tracked by The Hulbert Financial Digest, an industry watchdog service. It did so with an annual performance of 20.0% in the period, almost a full percentage point a year better than the highest ranked Hulbert newsletter and about twice the performance of the major averages in that decade.

The AAII "Shadow Stocks" emphasize one main characteristic: low price-to-book-value. Book value means the total assets of a company minus what it owes. Other terms for book value are shareholder's equity and net asset value. To qualify for inclusion in AAII's "Shadow Stocks" list (updated approximately monthly), a stock must have a current price-to-book-value of 0.8 or below. Other rules also apply, such as small market capitalization and positive earnings, but the book value criterion is fundamental.

The innovative financial analyst, author, and teacher, Benjamin Graham, pioneered the focus on low price-to-book-value equity selections. He reasoned that some other value criteria, such as the popular low P/E, or low price-to-earnings ratio, are more susceptible to accounting manipulations and suggested that, sooner or later, a low price-to-book stock's price will rise to (or above) its net asset value, resulting in profit for the "bottom fisher" type investor. And, indeed, in over a half-century of his firm's experience with the purchase and sale of low P/Bk stocks that initially had price-to-book ratios of about 0.8 or below, they noted annual total returns averaging in the 15-20% range.

Despite both Ben Graham's record and that of AAII and others, as well as the relative simplicity of finding sufficient low P/Bk candidates from which to choose, this investment approach has never truly caught on. And, for a contrarian or value investor, that is definitely a good thing! "Too many cooks spoil the broth," as the saying has it. Chances are, if most investors jumped on the low P/Bk bandwagon, the bargain status of the better picks in this genre would disappear, the stocks' prices being bid up at the first mere whiff of savory value, so that this currently excellent buying-at-a-discount technique would no longer be profitable.

As it is, happily even recommendations here of low price-to-book-value stocks have fared well. While this proves nothing about future returns, the low P/Bk stocks we suggested in the 11/02 issue, "A Basket of Low Price to Book Bargains," had an average annual performance of 24.5%. We did an update in the 11/04 issue, "Revisiting Low Price to Book Stocks," and the assets recommended then are up 136% (through 4/16/07), for an annualized performance of 43%.

It may be reasonably argued that, since one of those five recommendations (Vulcan International) was delisted and rendered a less liquid "pink sheet" equity in late 2005 (though it is still trading and was up about a third from the 11/04 price when last bought and sold, in February, 2007), we should not count VULC.PK as anything but a total loss. While I have sold "pink sheet" assets more than once at good prices, I accept that they are not as convenient as exchange-listed stocks. Still, even if the result for Vulcan Int'l. were a 100% loss, the gains for the other four 11/04-suggested low P/Bk stocks were good enough (one, MFW, for instance, up over 300%) that an investor's overall 5-stock portfolio would have gained 110%, for annualized increases of 36%, in the 2.4 years since that essay was published.

In case this strategy has appeal, here are five new picks, chosen from the bottom 10% of P/Bk assets (but with the caveat that these bargains do not look so enticing as did the selections in 11/04, the current bull market overall being now somewhat long in the tooth, so that, to my eye at least, few if any screaming buy classic value stocks remain):

Merix Corp.MERX$8.000.760.4014.980.36
Nashua Corp.NSHA$9.150.840.2115.750.07
Planar Systems, Inc.PLNR$7.630.800.6135.490.01
REX Stores Corp.RSC$16.880.760.5117.210.15
Source Interlink Companies, Inc.SORC$6.850.760.1924.820.36
(Statistics effective at 1:30 PM Central Time, 4/16/07)


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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