Value that sizzles

I bought into Fairfax Financial when it was hit by a tsunami of bad news in 2002. Short sellers were betting it would collapse—which is one reason I thought it was a buy.

I like beaten-down stocks because I’m a contrarian and a value investor. I think that desperate situations such as Fairfax in 2002 are the ones that hold the potential for the biggest profits.

Most people, though, hesitate to wager a big chunk of their hard-earned money on distressed stocks—and for understandable reasons. One problem with investing in companies like Fairfax is that you may have to wait years to see a profit. Another problem with deep-value investing is that it’s not at all unusual to buy into a beaten-down firm, then watch it get even more beaten up. This can be deeply stressful.

A good way to sidestep these problems is to marry the frugality of value investing with the price action of momentum investing. You buy cheap stocks, but only after their prices have rebounded. By looking for stocks with a bit of price momentum, you are waiting for the market to signal that the worst is over for the firm.

To find stocks with both value and momentum, I started by looking for stocks trading at low price-to-sales ratios, because this is a strong indicator of fundamental value. From this group I then selected the stocks that had achieved the biggest price gains over the past year. Finally, I applied a bit of subjective judgment and picked six of what I consider the best investments. (You should, of course, do your own research before buying any of these stocks.)

The first on the list is my old friend Fairfax (FFH, $253.50). Widely considered a dog until recently, the Toronto property insurance company has shot up 71% in the last year. Like other property insurers, it benefited from the absence of any major hurricanes to dent its profits. In addition, Fairfax placed a big bet on a bust in the U.S. mortgage market and it appears to have made hundreds of millions of dollars this summer from that bet. Despite all the good news, Fairfax trades at only 1.5 times book value and at a forward price-to-earnings ratio of a mere 10. It has lots of room to move higher.

Martinrea International (MRE, $17) is the zippiest of the six stocks I selected. The auto-parts maker from Vaughan, Ont., has gained 127% since last year. The company has picked up several smaller auto-parts firms and has the capacity to buy even more companies in the distressed auto industry. Management boasts of the company’s strong balance sheet and robust cash flows.

I’m pleased to see Linamar (LNR, $25.65) pass the momentum test after suggesting it to MoneySense readers in the February/ March 2007 issue as part of my list of low price-to-book-value darlings. The autoparts firm from Guelph, Ont., has gained 85% since the start of the year. Much like Martinrea, Linamar has been an opportunistic buyer of other auto-parts companies. While Linamar is not as cheap as it was this spring, its prospects are still good.

Laurentian Bank (LB, $42.18) also made my list of low price-to-book-value darlings this past spring. It has gained 39% since the start of the year. As a long-time stockholder, I’m delighted with its move. But Laurentian remains the ugly duckling of the Canadian banking industry. Hobbled by a union, it continues to trade at a price-to-book value ratio of only 1.3, about half of what other Canadian banks fetch. I expect Laurentian to continue to grow its earnings and expect its stock price to go even higher.

Bombardier (BBD.B, $5.89) powered its way onto my momentum list this summer with a 76% gain since last year. Despite the advance, the Montreal aerospace manufacturer still sports a low price-tosales ratio of 0.7. I’ll admit to being a little cautious on Bombardier’s value pedigree as it only earned a dime per share last year. Also, its forward price-to-earnings ratio stands at 18, which is rather rich for my taste. But, based on recent gains, the market seems to be sniffing out a bargain at Bombardier.

I’ll round out the list with a smaller, more daring stock. Danier Leather (DL, $9.30) has gained 58% since last year and trades at a reasonable price-to-sales ratio of 0.4. The last few years have been difficult for the Toronto fashion retailer. Its U.S. expansion failed and management lost touch with the customers. But the company is turning itself around. It has closed underperforming stores and improved profits in recent quarters. As a stockholder I’m hoping that Danier will return to past levels of profitability.