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Looking for value in a ‘zombie economy’

All it took to temporarily halt a dismal market slide last week were a few mildly conciliatory words from House Republican leader John Boehner after what he called a constructive meeting Friday with President Barack Obama. But such is the markets' increasingly fragile state that this tiny shred of positive news on the U.S. fiscal front will buoy investor confidence for about a nanosecond.

Former Federal Reserve chief Alan Greenspan has already done his part to add more fuel to the volatile mixture of noise, numbers and nerves that have been driving the markets of late. "The markets will crater if we run into any evidence that we can't solve this problem," the old fiscal cliff dweller told a Bloomberg Television interviewer. "If we get out of this with a moderate recession, I would say the price is very cheap."

He was talking about the fiscal mess, of course. But he could just as easily have been referring to the never-ending European debt melodrama or the ratcheting up of rhetoric and missile attacks in the bubbling Middle East cauldron, both of which have been rattling investors.

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Name the worry du jour, and it's bound to have something to do with potentially market-slamming events in some corner of the world or another. But it's all just so much noise to veteran global equities specialist Paul Ehrlichman.

The investing world is divided into two camps, he says over a burger lunch at a Toronto hotel dining room. There are the "super bearish, end-game debt-trap people" and the optimists who believe all the monetary easing, stimulus spending and the like have laid the ground work for more than just inflated stock values. "This can and does create tremendous volatility," says the head of global equity with Global Currents Investment Management in Wilmington, Del., part of the Legg Mason group.

The noise from each side cancels the other out, leaving only the all-important signal that warns of a slow-growth "zombie economy" ahead. And that's what investors should be focused on. There is "no big fat-tail event coming," Mr. Ehrlichman says confidently of the fiscal cliff, euro debt blowup, Chinese crash and other nightmare scenarios. "We've anesthetized the global economy. We are going to grow slowly. There are companies that are positioned for that and there are companies that aren't. Like in any good zombie movie, not everyone makes it out alive."

The ideal investment strategy in such an environment runs counter to the herd mentality, more colourfully described by Mr. Ehrlichman as "single-cell amoebas" plunging into whatever seems to be working at the moment.

Instead, investors should set aside their morbid fascination with the geology of fiscal cliffs and focus on individual companies best positioned to survive the zombie economy, thanks to their ability to develop new products and markets, shed unproductive operations, buy cheap assets from falling competitors and safeguard strong balance sheets.

"The dirty little secret of value investing is that we invest in companies where there is obviously a tremendous amount of uncertainty," he says. "We are fishing in a pond that generates positive surprises and negative surprises. The forecast error amongst low-quality cheap stocks is eight times that of higher-quality companies. So we're going to a place where people make a lot of mistakes and analysts can't forecast earnings. But mostly they're overly optimistic."

Based on historical trends, "you're more likely to experience a negative surprise than a positive surprise. But we all think we're special, so even though negative surprises outnumber positive surprises 3 to 1, we all think it's not going to happen to us."

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The solution, he says, is to avoid even battered stocks if earnings expectations are unrealistically high.

But don't companies with low expectations often meet them? Surely, some are dirt-cheap because they deserve to be. "That's the fundamental part of the value trap that we're always faced with. Value managers get the opportunity to buy dying brands and obsolete technology, because most of the value traps we see come in consumer discretionary and technology names. We all get to buy RIM or Nokia, so we have to be very careful about companies that are losing market share or having their industry disintermediated."

His current list of downtrodden but promising names includes fashion brands Laura Ashley and Esprit Holdings, food heavyweight Campbell Soup and Canadian investment firm Canaccord Financial.

"Our ideal stock is cheap, undervalued and under-earning and with low expectations. So we want profits to be depressed, valuation to be depressed, but very importantly, expectations to be depressed. That's the thing a lot of value managers don't like to talk about, because it's very behavioural."

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