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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.

Given that we live in an age of endless analytical data, intricately interconnected global markets, and esoteric financial instruments, it's amazing to think how simple the concepts behind good investing are. Consider what hedge fund guru Joel Greenblatt said recently in summing up the philosophies of two of history's greatest investors:

"Ben Graham said, 'Buy it cheap,'" Mr. Greenblatt told CNBC, "and his best student, Warren Buffett, added one little twist that made him one of the richest people in the world. He said, 'If I can buy a good company cheap, even better.'"

While they are obviously simplifications, those characterizations get at the heart of Mr. Graham's and Mr. Buffett's approaches. And that simple "little twist" to which Mr. Greenblatt refers – adding a quality component to a value investing approach – is at the core of Mr. Greenblatt's own "Magic Formula," and at the core of the strategies used by most of the other investing gurus I follow: buying good companies at cheap prices to win big over the long haul.

But while the concept is simple, a rather fascinating dynamic is at play within what I'll call the "Quality-Value Synthesis." It involves what happens when you separate the value and quality components.

Over the past several decades, numerous studies have shown that cheaply valued stocks outperform the broader market over the long term, confirming Mr. Graham's "buy it cheap" philosophy. You might expect the same to be true of quality stocks. It makes intuitive sense that you'd be better off investing in firms with high returns on equity and assets, and strong, consistent margins, rather than those with low ROEs and ROAs and weak margins, right?

Nope. Vitali Kalesnik and Engin Kose of Research Affiliates recently examined the performance of stocks picked using dozens of different "quality" factors (such as return on equity, return on assets, and margin stability) over the past 50 years or so. Their findings?

"Of the 40 measures we examined, 25 have positive performance, including six whose results are statistically different from zero," they wrote in a piece for ETF.com. "These results are indistinguishable from random occurrences." In other words, buying high-quality stocks in and of itself hasn't given an investor any advantage over buying low-quality stocks over the past 50 years.

But here's where things really get interesting: When they added value factors to the mix (focusing on cheap high-quality stocks), risk-adjusted returns improved. "Quality is not, in itself, a factor that generates a premium," they concluded, "but value investing conditioned on a properly specified concept of quality is a powerful investment strategy."

Put simply, the Research Affiliates study found that investing in quality stocks is a winning formula – if you are looking at a universe of cheap stocks. It's not the only study to come to that sort of conclusion. In a 2000 research paper, for example, Joseph Piotroski, a professor at Stanford University (and another of the gurus I follow), found that low price-to-book ratio stocks outperformed the market as a group not because they were in financial distress and thus higher-risk, higher-reward plays (as many thought); instead the group outperformed because of a small number of big winners within it – which tended to not be in financial distress. Those big high-quality winners helped low-P/B stocks outperform the market as a group even though most low-P/B stocks were actually losers, Prof. Piotroski found.

While there are a myriad of strategies that will beat the market over the long haul, I think you'll find that most stick to the numbers and use a diverse group of quality and valuation metrics.

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Using the Guru Stock Screener on Validea.ca, here are eight names that score highly based on a combination of value and quality strategies, including the models I based on the approaches of Warren Buffett, Ben Graham, Joseph Piotroski, as well as James O'Shaughnessy's Cornerstone Value quantitative method.

  • Metro Inc. (MRU)
  • Royal Bank of Canada (RY)
  • Maple Leaf Foods Inc. (MFI)
  • Stella-Jones Inc. (SJ)
  • Magna International Inc. (MG)
  • Shawcor Ltd. (SCL)
  • Pacific Rubiales Energy Corp. (PRE)
  • WestJet Airlines Ltd. (WJA) <QL>

John Reese

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