John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the Omega Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
After the speed and strength of last year's U.S. market surge, it seems that many North American investors' New Year's resolutions were to cut back on their stock holdings in 2014, with both the S&P 500 and the S&P/TSX Composite falling in the first few trading days of the year.
I think they're making a mistake.
Yes, the market's rise was rapid last year, and valuations jumped significantly. But that's what valuations do in bull markets, and we are far from astronomical valuation levels.
Perhaps more importantly, the stock market is not a monolithic entity but made up of individual stocks.
While the average valuation rose quite a bit over the past year, plenty of attractive, very cheap individual stocks remain.
By using fundamental-focused, value-oriented strategies, you can key in on some of these big-time bargains. My Validea Hot List portfolios are currently finding a number of well-priced, sound companies.
The Canadian version of the list has had two very strong years, returning 27.3 per cent and 30.2 per cent in 2012 and 2013, respectively, versus 4.0 per cent and 9.6 per cent for the S&P/TSX Composite.
A key to these portfolios' success, I believe, is the fact that these models don't just use one valuation metric to identify cheap stocks. That's important because sometimes short-term factors can make a particular metric – especially the price-earnings ratio – misleading (a one-time tax benefit that inflates earnings would be an example).
So, with broader valuations on the rise, where are these guru-inspired models still finding big bargains?
TransGlobe Energy Corp.
TGL shares have struggled, in part because the oil and gas explorer focuses its business on volatile Egypt and Yemen. But its shares are cheap – too cheap, according to a couple of my models. The strategy I base on the writings of hedge fund guru Joel Greenblatt thinks TGL is among the top 15 stocks in the Canadian market, thanks to its dirt-cheap 25.9-per-cent earnings yield. (We use earnings before interest and taxes divided by enterprise value to determine earnings yield, not a simple price-earnings ratio). The model also likes TGL's stellar 26.6-per-cent return on capital – a sign the firm is cheap more because of overblown fears than problems with its business.
My Peter Lynch-based model also likes TransGlobe. Mr. Lynch famously developed the P/E-to-growth ratio (PEG) to value stocks, and when we divide TransGlobe's 7.3 P/E by its 32.2-per-cent long-term earnings per share growth rate (using an average of the four and five year rates), we get a very low 0.23 PEG. (Anything under 0.5 is indicative of a big-time bargain.)
Alimentation Couche-Tard Inc.
This $15-billion-market-cap convenience store chain is rumoured to be among the suitors for U.S.-based Hess Corp.'s retail operations. Investors seemed bearish on the idea, with shares falling amid the speculation, but two of my models think the stock is a bargain worth a long look – and an interesting pair they are. My Warren Buffett-based model likes its consistency (the firm has upped earnings per share in all but one year of the past decade), strong 19.7-per-cent average return on equity over the past decade, and reasonable 5.2-per-cent earnings yield. My James O'Shaughnessy-inspired growth model, meanwhile, likes Couche-Tard, too, partly because it has raised EPS in each year of the past half decade and because it has a strong relative strength of 88 over the past year.
Joy Global Inc.
Benjamin Graham is known as "The Father of Value Investing," so it's on only fitting that we look at a pick from my Graham-based model. Right now, the highest-scoring U.S. stock using the approach is Joy Global, a Milwaukee-based mining equipment provider ($5.6-billion (U.S.) market cap).
Mr. Graham's "Defensive Investor" strategy – on which my model is based – was a stringent approach that required a firm to have a current ratio (current assets divided by current liabilities) of at least 2.0, and more net current assets than long-term debt. Joy has a current ratio of 2.07, and $1.5-billion in net current assets versus $1.3-billion in long-term debt, passing both tests.
Full disclosure: I'm long JOY.
John Reese