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What are we looking for?

Bargain U.S. stocks. With the Dow Jones industrial average at record heights and the S&P 500 not far behind, it's becoming tough to find stocks that aren't at lofty valuations. Today, we attempt to find the securities that still look cheap.

How we did it

Craig McGee, senior consultant at CPMS Morningstar Canada, gave us a look inside his company's 20-stock U.S. valuation strategy.

The CPMS approach begins by narrowing the U.S. market down to a more reasonable size by looking only at stocks with a daily average trading volume of at least $2-million (U.S.) and a market capitalization of more than $500-million. In addition, it requires a stock to be followed by at least three analysts.

The strategy seeks stocks that are trading both at low price-to-earnings (P/E) multiples based on reported earnings and also at low price-to-cash-flow (P/CF) multiples based on reported cash flow. The CPMS approach also favours stocks with high recent upward revisions to earnings estimates.

To ensure an adequately diversified portfolio, the strategy allows no more than five stocks from any single industry group.

More about CPMS

CPMS, a division of Morningstar Canada, provides quantitative North American equity research and portfolio analysis to primarily institutional clients. It covers more than 700 Canadian and 2,200 U.S. stocks, and spends a lot of time adjusting for unusual accounting items in each company's quarterly results to make sure screens can perform correctly.

What did we find out?

Mr. McGee reports that the U.S. Valuation model has led the pack of pre-defined CPMS strategies so far this year with a total return of 24.7 per cent. By comparison, the S&P 500 has generated a total return of 9.7 per cent.

Over the past 10 years, the model's annualized return has been 21.7 per cent versus 8.2 per cent for the index. It appears that buying cheap stocks has been a wonderful formula for navigating the past decade.

Be aware, though, that the market can change its mood quickly and there are long periods in which value stocks do not shine. As always, before buying any of the stocks here, do your own research.