Best value seen in U.S. stocks

For slimmer or fatter, I enjoy savouring jujubes while relaxing after a hard day’s work. I’ve a particular affinity for the berry-flavoured ones. I’m not keen on the licorice candies, which accumulate unmolested at the bottom of the bag.

Buying a stock index is like buying a bag of jujubes. It contains a few succulent stocks, but comes with its fair share of duds. I like to focus on stocks with the best prospects instead of buying them all.

It’s an approach I’ve used with the S&P 500 and I’m pleased to report it has been very profitable so far. The 20 value stocks I highlighted early last year have climbed an average 58.4% since then whereas the index only advanced 29.9% over the same period. The value group beat the index by a whopping 28.5 percentage points (in U.S. dollars, not including dividends.)

Before you get too excited, I hasten to add such stupendous returns are the exception rather than the rule. I don’t expect my approach to post 50%-plus gains each and every year. (I’d be pleased as punch if they did.) More realistically, it should do relatively well over the long term and I hope it will beat the index. There are, of course, no guarantees and it may disappoint in the future. Nonetheless, I hope the recent gains will pique your interest in the surprisingly simple technique behind them.

It all starts with the big stocks in the S&P 500 that have several reassuring characteristics. Importantly, the index is stuffed full of the largest U.S. firms, which tend to be less volatile than smaller firms.

Beyond size, earnings matter. To be nominated for inclusion in the index a company must post four quarters of positive operating earnings. Once in the index it can report losses but a prolonged series of them will likely lead to its removal: particularly if its share price falls sufficiently.

How do I go about picking the juiciest value stocks from the S&P 500? I use two simple measures Benjamin Graham suggested in his classic book, The Intelligent Investor.

First, I focus on companies trading at low price-to-earnings ratios (P/E), because they offer large streams of income at a low price. Second, I stick to stocks with low price-to-book-value ratios (P/B), because they offer investors a discount to the value of their assets less their liabilities.

Keep in mind low ratios can indicate the market is worried about a company’s health—and sometimes the market is right. It’s wise to examine the source of concern carefully. Thankfully, the market often gets too depressed about the near-term outlook and tends to overly discount a company’s long-term prospects.

My version of the low-P/E and low-P/B strategy uses a two-fold sort. First I sort the stocks in the index by P/E, and keep those with the lowest 20% of positive ratios. This short list of stocks is then sorted by P/B, and only those with the lowest 20% of positive ratios are kept. That leaves 20 value candidates. You can find the full list online at moneysense.ca/valuehunter. Sixteen of the 20 are financial stocks or conglomerates. Here, I’ll highlight three that caught my eye.

I’ve followed Leucadia National (LUK), for years. Think of it as a junior Berkshire Hathaway that also sports a phenomenal long-term record. As with Warren Buffett, Leucadia’s Ian Cumming and Joseph Steinberg are getting on in years. Cumming has decided to start his long-delayed retirement, made possible after the firm acquired Jefferies and installed its CEO Richard Handler as Leucadia’s new CEO. Handler looks promising but it’s not clear he can live up to Leucadia’s stellar past growth record. Still, at 12 times earnings and 1.2 times book value, the firm looks like a good value.

Allstate (ALL) was banged up in the collapse of 2008-2009 and is only starting to regain its former glory. Despite the big bump, the firm is nicely profitable and its book value per share has surpassed levels seen before the fall. However, the company trades at depressed multiples, suggesting there is still room for its stock to rise. It pays a dividend yield of 2% for those willing to wait for better times.

If you have an appetite for risk, consider JP Morgan Chase & Co (JPM). It managed to survive the downturn of 2008 and has gone on to do quite well. Profits have recovered and book value per share has climbed to new highs. Still, investors remain leery of it and of big financial firms in general. That helps explain why its stock trades at only nine times earnings and 0.9 times book value. It also pays a 3.1% yield and, should the economy continue to recover, its dividend will likely grow nicely.

Picking individual stocks is not for everyone and value stocks can disappoint. It’s a good idea to opt for a diversified portfolio to avoid being overly hurt should a few stocks fail. Do your own research before buying any investment. M