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Three beaten-down stocks that fit Warren Buffett’s patient investor style

John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.

If there's one thing that's hard to persuade investors to be, it's patient.

The urge to chase the hot idea or the manager with the dazzling recent track record is incredibly powerful. The resolve to resist crowd mentality can falter when it seems as if everyone else is winning and you've been left behind.

Imagine hiring a manager in 1997 and for the three year period to 2000, he clocks a gain of 65 per cent. That sounds pretty good, but remember: It was the roaring 1990s, and the technology-fuelled boom was all anyone could talk about. Dot-com after dot-com soared. During the same three year period, the Standard & Poor's 500 rose 107.6 per cent. That means your manager with the decent track record got beaten pretty handily and trailed the market by more than 40 per cent during this period.

Would you stick with him?

Ask yourself why you hired this manager in the first place. Investors who do their homework look at managers for various reasons, but primarily to see whether they offer something others do not. Maybe it's a style or strategy you find intriguing. Maybe it's a risk-taking profile or a diversification strategy that catches your eye. The manager isn't brand new and the fees look reasonable. Ideally, you pick this manager because you believe in the strategy and are willing to stick with it year in year out regardless of short-term glitches. None of this has changed just because he lagged the market for three years.

But investors finding themselves in this situation are often tempted to flee for other managers. Three years seems to be the hurdle over which most investors will bail out of a fund in search of others if the performance is lacking. This is where a lack of patience can be costly. The fact of matter is, the fund managers with the best track records over a decade spent at least three years underperforming others during that time. This was the conclusion of Joel Greenblatt, the author of The Little Book That Still Beats the Market.

Mr. Greenblatt's analysis was that while these otherwise top-performing managers spent some time in the basement, they would go on to outperform others over the longer run. Investors who cut and ran missed out on that opportunity, and took on the cost of selling out at a low.

Going back to your manager who underperformed from 1997 to 2000: Now imagine he went on to notch a 159-per-cent gain for 2000 to 2007. And consider that he outshined the paltry 14-per-cent gain for the S&P 500 over the same period. Investors who stuck with him would have caught up their underperformance and then some. If you bailed out before, you might be kicking yourself now.

It's a lesson we've talked about before. No one manager is going to beat the market all the time, and the patient investor has the steely determination to stick through thick and thin. Even professionals with years of experience can fall behind when markets are outperforming, as they have in the past year or so.

Getting back to your manager. Let's say it was dark times from 2008 to 2011 and he lost 19.5 per cent while the S&P lost just 6.4 per cent. The same manager rallies for the next three-year period, gaining back 96.8 per cent against the S&P's 74.6-per-cent gain. In the most recent two years (2015 and 2016), your manager slipped to 8.5 per cent versus the S&P's 13.5-per-cent gain.

Despite the seesaw of performance, the investor that allocated to this manager and stuck with the strategy, particularly at the outset when returns trailed the market, was handsomely rewarded. The overall long-term performance from 1997 to 2016 was 632 per cent compared with 339 per cent for the S&P 500.

Who is this manager who has deviated so far from the market and gone through extended periods of underperformance? Is it a small-cap manager or a manager investing in high flying growth stocks? No, it is in fact the opposite. It is none other than the best investor of this generation, Warren Buffett.

At Validea, we have designed a model to track Mr. Buffett's patient investor style. We track both U.S. and Canadian portfolios. In the United States, the portfolio is up 165.4 per cent since 2003, outpacing the market by 33.6 percentage points, and in Canada the Buffett-inspired portfolio is up 141 per cent compared with 27 per cent for the S&P/TSX since August, 2010. Here are three stocks in the current U.S. patient-investor portfolio that have sold off recently and could be buying opportunities.

Allegiant Travel Co. (ALGT-Q) – This is a leisure travel company that owns Allegiant Air, a budget airline. Mr. Buffett long steered clear of airline stocks but has recently taken a liking to them. The company has reliable earnings growth and a 25-per-cent return on equity, on average, over the past 10 years, while the stock trades at a price-to-earnings multiple of 10.7.

NIC Inc. (EGOV-Q) – This is an information services and software provider for federal and state government offices throughout the United States. It has an expected average rate of return of about 19 per cent for the next decade based on the model Mr. Buffett uses to evaluate stocks.

NetEase Inc. (NTES-Q) – These are American depositary receipts in a Chinese technology that provides Internet services and games. It hits all the criteria Mr. Buffett uses to evaluate stocks, including a consistently higher-than-average return on equity of 24 per cent.

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