Widely followed stock market expert Jeremy Siegel has developed a strategy that he says is particularly effective in difficult markets in which broad market averages are suffering.

Specifically, your clients can reap superior returns if they focus on stocks with high dividend yields and low price/earnings ratios, says Siegel, author of Stocks for the Long Run and professor of finance at the University of Pennsylvania’s Wharton Business School.

For example, for the 10 years between 2000 and 2010, investors in the U.S. market made virtually nothing, with an average annual return of 0.43% on the S&P 500 composite index. However, the 100-stock quintile with the highest dividend yield each year scored an average annual gain of 5.09% during the same decade, while the quintile with the lowest P/E ratios raked in 9.58%.

“Research shows that the strategy outperforms consistently — not every year, but not just in isolated periods,” says Siegel, who spoke recently at a luncheon in Toronto. “It outperforms about two-thirds of the time, and the outperformance has been most substantial in bear markets.”

Siegel has long been a believer that investors are better served in stocks than in any other financial asset class — and extreme market volatility has not changed his mind. But Siegel recently has refined his strategy to target specific types of stocks rather than broad market indices.

Siegel conducted research on the broad S&P 500 going back to 1957. He sorted the stock market into five quintiles, according to P/E ratios. The 100 stocks that had the lowest P/E ratios in December of each year outperformed the S&P 500 by roughly 3% during the 53-year period between 1957 and 2010. In the same time frame, the average annual total return of the S&P 500 was 10.2%, while the average gain of the quintile with the lowest P/E ratios was 13.2%.

Siegel also sorted the S&P 500 stocks into quintiles according to dividend yield. The stocks with the highest dividend yields showed an average annual return of 12.6%, which also was higher than the S&P 500’s return.

“What money manager wouldn’t want to be three percentage points above the S&P for more than half a century?” says Siegel.

Once a proponent of ordinary index investing based on the superior long-term returns of stocks relative to bonds or treasury bills, Siegel refined his views after the high-tech bubble of 2000.

“I saw the tech stocks go up beyond their fundamental values,” he says. “As an index investor, you hold stocks in proportion to their market value and you don’t sell, which means the weightings can become substantial. I questioned whether that was the best way to invest.”@page_break@Siegel says even quality companies can become overpriced — and they are risky when they become too expensive.

“There are good firms and bad firms, and good stock market values and bad stock market values,” he says. “The two are not the same thing, and a lot of mistakes are made by thinking they are the same.”

Now, Siegel is convinced it’s better to tilt toward high-dividend or low P/E stocks — essentially, a “value investor” approach. He says today’s market offers opportunities for investors because the S&P 500’s average P/E ratio of 13 times estimated 2011 earnings is lower than the long-term average market’s P/E ratio of 15 times and the level of around 30 during the tech boom. At the same time, returns in competing investments are low.

“What is the competition for the stock market today?” Sie-gel asks. “A 10-year treasury bond pays only 2.8%. There is no competition.”

In examining the superior long-term performance of stocks, Siegel has looked at the data going as far back as 1802. After more than 200 years, US$1 invested in U.S. stocks would be worth almost US$700,000 at the end of 2010; if invested in bonds, worth US$1,530; in T-bills, US$292; and in gold, US$4.02. By contrast, the U.S. dollar has depreciated to US5¢.

After inflation, this translates into a real average annual return of 6.7% for stocks, 3.6% for bonds, 2.8% for T-bills, 0.7% for gold and minus 1.4% for the US$.

“In the short run, stocks are the most volatile asset class of all,” Siegel says. “But in the long run, they are the best in terms of return — and the most persistent.

“With a 6.7% annual return, you can almost double your money every 10 years,” he adds. “That means that, on average, stocks have doubled in value, after inflation, every decade for the past two centuries.”

Most investment markets around the world are cheap relative to historical P/E ratios, Siegel says, but he points out that there is a lot of risk aversion on the part of investors.

Personally, he says, he has most of his money in stocks, with a smaller amounts in cash and high-return “junk” bonds.

“There have been two major bear markets in the past 10 years, and the last one was the worst since the 1930s,” he says. “The impact doesn’t wear off overnight. Time heals, and the fear will recede. Better performance will also increase confidence.”

Siegel does not foresee another recession, forecasting a pickup in U.S. economic growth in the second half of this year, provided there is no significant rise in oil prices. IE