Three stocks that are cheap because of fear, not fundamentals

John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.

In today's Internet-centric world, the first thing many of us do before going on a vacation is hit the review and ratings websites – TripAdvisor, Yelp and the like. We want to make sure that we don't stay in the "sketchy" part of whatever town we're visiting; we want to make sure that we get to go to the restaurants that provide the most bang for our buck; and if we need transportation to and from an airport or elsewhere, we want to make sure that we are using a reliable service. In short, we want to make our vacation as worry free – and fear free – as possible. Who could argue with that goal?

In the stock market, however, many of the best investors seek out the proverbial "one-star reviews" when deciding where to put their money. They want the hotel in the sketchy part of town, the restaurant with horrible service and an inordinate amount of food poisoning incidents and the shuttle service with a reputation for delays and breakdowns. That's because price is correlated with the public sentiment about a stock. And while vacationing in a worrisome one-star locale can leave you with bad memories, buying stocks in one-star places can actually lead to great returns.

In a recent interview with ETF.com, top strategist Rob Arnott of Research Affiliates said fear is necessary in investing. "You don't get bargains in the absence of fear," he said. That's why he thinks European stocks and emerging-market stocks – both of which have major fears hanging over them – look much more attractive right now than stocks in the United States, where the economy is strong and markets are near record highs. And it's why another investment guru, Mark Mobius, says he's been buying stocks in much-maligned Greece.

Implicit in all of this is a notion about which David Dreman, the Canadian-born investor and behavioural finance pioneer, has written extensively: that people are emotional creatures, and have penchants for overreacting. Mr. Dreman's research showed that people overvalue popular stocks and undervalue unpopular stocks (those that are getting negative headlines and surrounded by fear). And he found that people do this not occasionally or once in a while, but systematically. That means unloved stocks often have such low expectations that if the company just does a little better than awful, the stock rises. The same is true for unloved regions as a group. While taking a vacation that's a little better than awful is a waste of money, owning unloved stocks that do a little better than awful can be quite lucrative.

Of course, there are risks in investing in one-star regions; the fact that there are problems in these areas is precisely why stocks are cheap there. For most investors, I think the point is thus not that you should load up exclusively on these types of stocks. Instead, it's that you shouldn't avoid them altogether – don't be afraid to include them within a broader, well diversified portfolio.

You also don't want to start blindly picking just any stock from these regions. You should make sure that any company you invest in has strong financials and fundamentals. The goal is to invest in good companies whose shares are cheap because of fear, not companies whose shares are cheap because of real long-term problems.

What are some companies that fit that bill right now? Here are a few that get high marks from my Guru Strategy investment models, which are based on the approaches of Mr. Dreman and other highly successful investors.

Sasol Ltd. (SSL-NYSE): An emerging-market energy play – talk about a fear-filled stock. This South Africa-based company has been shutting down operations and changing its dividend policy amid the oil price free fall. But my Benjamin Graham-based model thinks its shares are victims of overreaction. It likes Sasol's balance sheet – the firm has twice as much in net current assets ($5.5-billion U.S.) as it does long-term debt ($2.7-billion), and price. Shares trade for just 9.7 times three-year average earnings and 1.4 times book value.

Unilever PLC (UL-NYSE): With head offices in London and the Netherlands, this home-goods and food-products firm counts Lipton, Hellmann's, Dove, Slim-Fast, and Vaseline among its big brand names. Unilever does a significant amount of business in Europe, and many are still worried about Europe's economy. My James O'Shaughnessy-inspired model likes Unilever's size ($125-billion market cap), $2.51 in cash flow per share, and solid 3.5-per-cent dividend yield.

CNOOC Ltd. (CEO-NYSE): This oil and natural gas operations giant (the Chinese National Offshore Oil Corp.) gets high marks from my Dreman-inspired model, which sees the stock as a contrarian pick because its price-to-earnings (6.7) and price-to-cash flow (3.4) ratios are both in the market's bottom 20 per cent. But the company, which has a $64-billion market cap, has stellar fundamentals that include 30-per-cent pretax profit margins, a 36-per-cent debt-to-equity ratio, and 5.1-per-cent dividend.

Disclosure: I'm long SSL and CEO.