How to find needle-in-the-haystack stocks

Tracking the every move of big stock indexes has become something of an obsession for many investors. After all, the rise of index funds means that a great deal of money is riding directly on every twitch and twitter.

But the indexes can also be employed to good effect by investors who want to pick and choose their own stocks. By limiting yourself to stocks within an index you can benefit from the methods used to construct the index in the first place.

Let’s focus on the S&P 500, which forms the basis of several of my stock selection strategies. The index tracks 500 prominent U.S. stocks selected by Standard & Poor’s. It turns out their decisions are based on more than just the numbers: some judgment enters into the picture. As a result, when you opt for the S&P 500 you get a very mild form of active management.

But you can see some significant effects at the margin—that is, when stocks are added to or removed from the index. This is done fairly infrequently, but it happens inevitably due to mergers and acquisitions, as well as bankruptcies and other business failures.

When it comes to additions, size is obviously a consideration for the S&P 500. New stocks are generally—but not always—required to have market capitalizations (shares outstanding times price per share) in excess of $4 billion. Indeed, the S&P 500 is currently dominated by some stupendously huge firms like oil giant Exxon Mobil (XOM) and high-tech Apple (AAPL).

But beyond size, earnings also matter. To get into the S&P 500, a stock must sport four quarters worth of positive operating earnings. That’s a fairly subtle requirement, but when combined with size it further leads to a quality bias for the index.

In other words, by sticking to stocks within the S&P 500 you are automatically picking from economically important firms that are likely to be able to weather a storm.

That’s why I decided to use the S&P 500 as my starting point for an adventure in value investing about a year and a half ago for MoneySense. Before getting into the details, let’s take a quick look at how we’ve fared since last time.

As it turns out, the venture has been nicely profitable. The portfolio of 20 value stocks I selected advanced 20.9% since the original article came out in May 2010, while the S&P 500 (as measured by the SPY exchange-traded fund) only gained 16.5%. Neither figure includes dividends which would have further boosted returns.

How did I pluck value from the S&P 500? I used two simple measures Benjamin Graham suggested in his classic book, The Intelligent Investor. First, I opted for stocks trading at low price-to-earnings ratios (P/E), because they offer large streams of income at a low price. Second, I also wanted stocks with low price-to-book-value ratios (P/B), because they offer investors a discount on stockpiles of assets.

Just keep in mind that low ratios can indicate that the market is worried about the company’s health—and sometimes the market is right. So it’s wise to examine the source of the concern carefully. But investors often get far too depressed about the near-term outlook and discount the longer term.

My version of the low-P/E and low-P/B strategy starts with the stocks in the S&P 500. I then apply a two-fold sort. First I sort the stocks by P/E, and keep those with the lowest 20% of positive ratios. This shortlist of stocks is then sorted by P/B, and only those with the lowest 20% of positive ratios are kept. That leaves me with 20 value candidates. The full list, along with a variety of facts and figures for each stock, can be found at MoneySense.ca (see full link below). But I’ll highlight three with particularly low ratios, starting with a stock from my last report.

Rowan Companies (RDC, $30.33) is a contract-drilling firm with global operations. It works on land but it also takes on hard-to-drill deep offshore oil wells—an area that is still recovering from the BP disaster in the Gulf of Mexico. Times are getting better, but the firm still trades at a bargain 5.1 times earnings and 0.86 times book value.

The next two stocks are a little more controversial. American International Group (AIG, $23.20) is infamous for the role it played in the financial collapse of 2008, when it was rescued by the U.S. government, which is now its largest shareholder. While the firm’s health seems to be improving, you can bet the government will dump its shares as soon as it can without losing too much face. The presence of a motivated seller is a big reason why the stock trades at only 0.51 times book value. (One might also question the quality of its book value given the recent past.) As a result, this one clearly requires investors with both a long-term focus and a strong stomach.

Citigroup (C, $26.31), a beleaguered U.S. bank, is perhaps in slightly better shape than AIG, but it also comes with a big side order of risk. At least the price seems good at 0.43 times book value and 6.9 times earnings.

Just be aware that picking individual stocks is not for everyone, and value stocks can disappoint. That’s why it’s often a good idea to opt for a fairly diversified portfolio: that way you can avoid being overly hurt should one or two of your stocks fail. If you need more value picks to round out your portfolio, you’ll find my complete list in the chart below.

Norm’s picks:

* Price as of Jan 1, 2012