By definition value investors are always on the lookout for cheap stocks, but as anyone who's fallen into a value trap knows all too well, sometimes a stock is cheap for a reason. A stock can trade at a deep discount to its forward or trailing earnings, sales, book value or what have you, lending it all the appearance of a bargain, but still languish or underperform the broader market for years. Or decades.

There's no magic formula for separating the true value plays from the duds, but one element to consider is a stock's so-called quality. A portfolio of cheap, high-quality stocks should, theoretically, provide superior returns over long periods of time and a common way to measure quality is by looking at a company's return on equity (ROE).

ROE describes the amount of net income a company generates as a percentage of shareholders' equity stake in the business. Essentially, it shows how adept management is at generating a return on the cash investors have put into business (as opposed to cash the company has borrowed from creditors).

So, for example, a company with an ROE of 20% means management has created $20 worth of assets for every $100 originally invested in the business. As a general rule of thumb companies with solid returns on equity, say 15% to 20%, do well by their shareholders. They generate enough cash to fund operations while also returning some of it in the form of dividends or share buybacks.

Looking for companies with large market caps and high ROEs trading at a discount to their own price-earnings (P/E) multiples is a good starting point in sussing out stable defensive investments that will provide market beating returns over the long haul. Using data from Thomson Reuters and Capital IQ, we screened for stocks with market caps of at least $10 billion and five-year average ROEs of at least 40%. Additionally, the shares had to be trading at a discount of at least 10% to their own five-year average forward P/E and have a 10-year total return greater than that of the S&P 500 ($INX) (which has essentially been dead money).

That left us with nine names. See the chart below.



Interestingly, the top three spots for five-year average ROE are held by noncyclical consumer stocks Colgate-Palmolive (CL), Avon Products (AVP) and Campbell Soup (CPB). These companies' share prices have all had their ups and downs over the years as they've tangled with higher input costs, migration of consumers to cheaper store brands or price pressure on the part of their retail partners, among other challenges. In addition to producing high returns on the money investors have contributed to their respective capital structures, they've creamed the broader market over the last decade.

True, Freeport-McMoran (FSX) has benefited from record-high prices for copper and gold, while Millicom (MICC) has gone gangbusters from in emerging markets in both hemispheres, but high ROEs still bode well for shareholders going forward.

Still, perhaps the biggest takeaway from these names is the importance of dividends. Microsoft (MSFT), the ninth name on our list, has seen its share price rise just 18% in 10 years, but add in the dividends and shareholders actually got a 47% return on their investments.

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11 Comments

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freebeerdc

trading at a discount to its own five year forward average P/E ratio? what on earth does that mean. the price a stock trades at is not a ratio, its a fixed cost per share.

is a forward average P/E ratio an average of current price to average future earnings? must be cause we don't know the future prices and this is a known figure.

so say a stock costs $10 now and it will make an average EPS of $2 a year, so it has a foward P/E ratio of 10 to 2, which is the same as 5 to 1, or 5.

what on earth would it mean to be trading at a 10% discount to a ratio of 5? a current ratio of 4.6 to 1?

in which case, would it not have been a lot simpler to say a stock that will have 10% avg earnings growth?

January 12 2011 at 3:18 PM Report abuse rate up rate down Reply
bdyftns

5 and 10 year 'averages' mean nothing. Beware the high averages of 5-8 years ago averaged in with the loses in '07,'08,09.

January 10 2011 at 4:29 AM Report abuse +2 rate up rate down Reply
ronsjigslures123

I noticed in his chart that FCX and one of favorites that i bought 3 1/2 years ago alone with Ford was good old healthy soup companys. People should buy all the soup comapny stocks they can stand and also buy all the silver they can stand, i have been investing in both for the past 3,4 and 5 years and have made a lot of money, for just a working person. When i sell my silver at 50 bucks a oz. i will retire for good. When gas hits 5 bucks a gal. food prices will hike also, many people will be buying ready made food products, soup is not the only companys ENTERING the ready made food market with new products, there are several others, do your reserch and you will find them, i have and bought some stock in a couple of them.

January 10 2011 at 2:26 AM Report abuse +2 rate up rate down Reply
shiloh1388

Uhh, how does Hollywood Aol feel it was so hot, then so not, then back a bit. Is it a good deal now????

January 09 2011 at 10:23 PM Report abuse +1 rate up rate down Reply
shiloh1388

Since the Nasdaq and New York Exchange have five thousand plus companies, it's nice that nine of them could be good.

January 09 2011 at 10:21 PM Report abuse +1 rate up rate down Reply
CnOWrms1

$4.2671 = copper price / pound on Jan 07, 2011.

January 09 2011 at 9:55 PM Report abuse +1 rate up rate down Reply
CnOWrms1

I should have bought copper two and a half years ago, when it was being stolen everywhere, off of air conditioners, etc. Would those copper thieves have been liberal perhaps, manipulating the stock market?

January 09 2011 at 9:45 PM Report abuse rate up rate down Reply
1 reply to CnOWrms1's comment
CnOWrms1

We don't even have copper pennies.

January 09 2011 at 9:50 PM Report abuse rate up rate down Reply
savemycountry911

We like utilities. Electricity is one of the last things people will give up.

January 09 2011 at 8:09 PM Report abuse +4 rate up rate down Reply
stonehw

the best stock today is GE I belive it has come back from the dead and will continue to grow

January 09 2011 at 3:34 PM Report abuse -1 rate up rate down Reply
1 reply to stonehw's comment
snellbd

As long as Imilt is CEO of GE, it will never amount to much. He is am ding-bat!!

January 10 2011 at 2:01 PM Report abuse rate up rate down Reply
thomas miro

if your looking for good value and a stock that will ma ke you money with low risk buy some xom

January 09 2011 at 10:35 AM Report abuse +2 rate up rate down Reply