7 Stocks Mined From The Bottom Decile

Whenever academics, geeks and quant jockeys get together to talk about markets and stocks, a few catch phrases are likely to dominate much of the conversation.

One is "anomalies" -- those pesky little factors that cannot be explained away by the efficient market theory. The other is decile. Learning those terms and combining them into a simple stock screen can produce a list of potentially winning value investments.

Anomalies and Deciles

The professors like to break stocks into grouping of 10 percent and refer to them as deciles. They then compare the performance of one decile to another.

For example, the bottom 10 percent stocks as measured by price to book value have continually outperformed the top 10 percent over time. Since this is not supposed to happen, the performance of this lowest decile is an anomaly.

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There are other anomalies that have developed over the year. The January effect, the Monday effect and the small cap effect are just a few that have been discovered over the years. Many of them get arbitraged away as they are discovered.

Some cannot be arbitraged away, however, because they are based on valuation levels, like the price to book value measurement, or because they contain a significant information advantage, like insider cluster buying.

Insider Cluster Buying

Insiders know more about their company that anyone else, and when several of them are buying within a relatively short period of time this contains valuable information. The only reason to break open the checkbook and buy shares in the open market is if you have a high degree of certainty that your stock is underpriced and believe the price will move substantially higher over time.

When looking at the price to book value anomaly, Professor Jospeh Piotroski made an interesting discovery.

In a study titled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers” he found that less than 44 percent of all low price to book value stocks earn positive market-adjusted returns in the two years following portfolio formation. It is small subset of the group that provides that outperformance.

Piotroski developed a financial rating system to help separate the good from the bad, but there are other ways to spot potential winners out of the bottom decile as well.

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It's possible to combine other anomalies with the low price to book value factor to find the potential winners. For example, Victor Niederhoffer and Jim Lorie did a study back in 1968 titled, "Predictive and Statistical Properties of Insider Trading," which found that stocks with three or more insider buys in a short period of time outperformed the overall stock market by a wide margin.

Further research by Jeffrey Jaffe of Wharton, Nejat Seyhun of the University of Michigan and others has confirmed the effectiveness of insider cluster buying. Why not combine low price to book value stocks with cluster buying to find those stocks with the potential to beat the market?

Double Anomaly Bottom Decile Stocks

It is a simple matter to run a screen for those stocks that trade below book value and have seen insider cluster buying in the past three months. Given the lack of a significant correction in three years and the market's more than tripling in five years, the list of double anomaly stocks is very short: seven names.

Chimera Investment Corporation CIM is a real estate investment trust that invests in residential mortgage-backed securities. The REIT trades right at book value and four different insiders, including both the CEO and CFO, bought shares in August.

New Mountain Finance Corp. NMFC is a business development company that invests in debt securities at various levels of the capital structure and makes direct equity investments in private companies. The shares are trading right at asset value, and five different insiders have purchased shares in the past three months.

Couer Mining Inc. CDE is a silver mining company with operations in United States, Mexico, Bolivia, Argentina, Australia, Ecuador and Chile. The stock is trading at just 40 percent of book value and five different insiders, including the chairman, the CEO and the CFO, have purchased shares recently.

Photronics, Inc. PLAB manufactures and sells photomasks used in the manufacture of semiconductors and flat panel displays. The stock trades at 90 percent of book value and three different insiders bought shares over the summer.

Hercules Offshore, Inc. HERO provides shallow-water drilling and marine services to the oil and natural gas exploration and production industry globally. The stock is trading at just 60 percent of book value and four different officers and directors, including the CEO, have purchased shares in the last three months.

NeoPhotonics Corp NPTN is a designer and manufacturer of PIC-based modules and subsystems for bandwidth-intensive, high-speed communications networks. The stock trades at 70 percent of book value, and three different insiders have been buying shares.

Charles & Colvard, Ltd. CTHR manufactures, markets and distributes Moissanite jewels for sale in the worldwide jewelry market. The stock trades at 80 percent of book value and three different insiders, including the CEO, have purchased shares in the past three months.

Combining insider buying with low price to book value stocks can help you mine the bottom decile to find those cheap stocks that have enormous recovery potential going forward.