Really Cheap Stocks Set to Rebound, Fund Managers Say

Tickers in this article: ABASX AVALX HWAAX

NEW YORK ( TheStreet) -- Not many mutual funds specialize in deep-value stocks, which sell for big discounts. The problem is that cheap companies are often troubled businesses that can sink in downturns. During the financial crisis, deep-value stocks were clobbered.

But this could be a time to consider shopping in the bargain basement, says Nick Erickson, an analyst for Brandes Investment Partners. Erickson has studied stocks that are part of the cheapest 10% of the market as measured by price-book ratios. He says the bottom dwellers have become unusually cheap since the financial crisis unnerved investors.

While the S&P 500 sells for two times book value, shares in the bottom 10th only trade at 0.55 times book value. In the past, deep-value stocks have sold for an average multiple of 0.8 times book. "When investors become fearful, they want to hold popular stocks that seem more comfortable," says Erickson.

Vadim Zlotnikov, chief market strategist of AllianceBernstein, says deep-value stocks move in sharp cycles, periodically lagging and then outpacing the market by wide margins. After hitting a trough in October 1990, deep-value stocks outperformed by 12 percentage points in the next 12 months. The margin was 7.5 percentage points after December 2000. Because deep-value stocks have lagged recently, Zlotnikov says we are due for another period when the outperformance could top 10%.

Make no mistake, depressed shares can be volatile. But by buying now and holding patiently, investors can achieve solid returns. During the 44 years ending in April 2012, stocks in the bottom 10th returned 12.8% annually, while the most expensive 10% returned 4.3%, according to Brandes.

No fund focuses exclusively on stocks in the bottom 10th, but there are some solid performers that hold stocks with multiples that are well below average. Top choices include Aegis Value (AVALX) , AllianceBernstein Discovery Value (ABASX) , and Hotchkis and Wiley Value Opportunities (HWAAX) .

Aegis holds an especially cheap portfolio. While the average small value portfolio sells for 14 times earnings, the Aegis holdings have a multiple of 5.6. "We are in a lonely place, but that is where a lot of the best returns have been," says Aegis portfolio manager Scott Barbee.

The cheap stocks have proved rewarding. During the past five years, the Aegis fund returned 5.9% annually, outdoing 95% of small value funds, according to Morningstar.

Barbee starts by screening for small-cap stocks that sell for less than book value. Before the financial crisis unfolded, about 120 names qualified for his list. But now there are 360 candidates, since investors remain wary of deep-value stocks.

Barbee aims to find unloved companies with decent cash flows. After buying, he typically holds for several years, waiting for the stocks to rebound. Most often Barbee is right, but he can take shareholders on a rough ride. In the turmoil of 2008, the fund lost 51.4%. Aegis bounced back sharply in 2009, returning 91.4% and outpacing 99% of peers for the year. "During the financial crisis, most of our holdings continued to have stable businesses, but the stocks fell because shareholders were liquidating their portfolios," he says.