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How to develop an eye for value

Gavin Graham, director of investments for BMO Asset Management, says of value traps: "There are some things that are cheap. And they will stay cheap for a very, very long time."

KEVIN VAN PAASSEN FOR THE GLOBE AND MAIL

STRATEGY

How to develop an eye for value

The market is strewn with bargains, experts say. The trick is to know how to find them - and how to avoid value traps

By Gavin Adamson

In a stock market that some experts say is littered with bargains, Calgary online investor Brian Twigg is keeping an eye out for value.

The 60-year-old retired accountant has been going online in the past six months exclusively to buy short-term fixed income products. And after watching triple-digit swings in recent weeks on the S&P/TSX Composite Index, he doesn't intend to wade into the equity markets any time soon.

But he admits to watching, with some interest, the financial services stocks - life insurance companies, for sure, and also the Canadian banks, because he likes the yields they offer with their dividends.

"They always come out in the end," says Mr. Twigg, who used to work in a bank and has several accounts with CIBC Investors Edge, the bank-owned discount brokerage based in Toronto.

"It's not an efficient market. But if I felt like we had reached the bottom, and there was some good evidence of it, you could make a killing in this market."

Even though Mr. Twigg is in the same quandary as retail and institutional investors alike - undecided about when, or if, to start buying - value fund managers say that watching dividends is one of several keys for retail investors looking to find value stocks. And they're out there, experts say.

"There's bargains all over the floor," says Kim Shannon, a Toronto-based value fund manager. "They may look a little toxic and scary, but they're bargains."

Investors should realize that long-term returns are always based on the price you paid when you enter the market, explains Ms. Shannon, who is lead manager for several Brandes Investment Partners mutual funds that are co-branded with her company, Sionna Investment Managers Inc.

And stock fundamentals such as dividends, price-to-book value and price-to-earnings ratio are all key tools in determining whether you're buying at a price that allows for long-term returns.

Such indicators may not be great for judging short-term timing, but then, nothing really is, says Gavin Graham, director of investments for BMO Asset Management in Toronto. "But they generally indicate a floor when they are moving down."

A good place to start in considering value stocks is to contrast them with growth stocks, which trade at higher earnings multiples, or the individual stock price over its earnings (PE) per share, expressed as a ratio.

Growth stocks trade at high PEs. Stocks such as Research in Motion Inc., the maker of the top-selling BlackBerry smart phone, for example, has been known to trade upwards of 30 to 1. Lately, Potash Corp., exporter of potash fertilizer to agricultural producers around the world, has also traded with a high PE, Ms. Shannon notes.

But when fear hits, growth stocks' prices drop just as quickly, she says. "The high-multiple stocks have lots of collapse room when the pessimism is high," she says. "Focus on low-multiple stocks; by definition that's value stocks."

Value stocks tend to trade with ratios in the low teens, at their highest mark. They often operate in lower-margin industries, such as retail foods, banking and insurance, and usually are steady earners, Ms. Shannon says.

On the other hand, value investors also want to avoid so-called value traps. "There are some things that are cheap," Mr. Graham says. "And they will stay cheap for a very, very long time."

While low price-to-earnings ratios are usually a good measure of value, he says that in a really bad market, such as the current turmoil, fast-falling earnings make it difficult to keep up.

Mr. Twigg watches dividend yields, and that's a potentially successful strategy, the experts say.

A company that can afford to pay out dividends is earning enough cash to sustain the payments to shareholders. "Focus on dividend," says Ms. Shannon.

She cites the book Active Value Investing, by Vitaliy Katsenelson. Investors know that the cash paid for each share contributes to yield, but Mr. Katsenelson takes it further, she says.

"He posits that dividend yield is so critical that in sideways markets, dividends may become 90 per cent of your total return. Normally it's about two-thirds," Ms. Shannon says.

By the same token, Mr. Graham says that if a company is dropping its dividend, that indicates serious troubles at the organization, because managers tend to drop it as a last resort. He notes that FannieMae, the embattled U.S. mortgage lender, dropped its dividend yield earlier in the year.

Finally, if a dividend is too high - say more than 150 per cent of the yield on a long-term U.S. Treasury Bond - it may not be sustainable. That, too, is a sign of trouble.

The classic value manager's tool is the price-to-book factor. When the value of all of a company's outstanding shares approaches the same value as all of its assets minus its liabilities, then it's a good value stock.

Ms. Shannon points out that the entire S&P/TSX Composite index is trading below its 50-year historical price-to-book ratio of 1.6, which could be good news for a long-term investor.

"If you've got three, better yet five, 10 or 15 years' time horizon, your long-term returns [from] entering the market here should be good," she says.

When it comes to bank stocks, which are trading near the bottom of their valuation range for the past 15 years, Ms. Shannon raises the issue of value traps.

"They're entering a period that may be tough for them cyclically," she explains. "When you enter a recession, loan loss provisions go up."

Mr. Graham, however, thinks the banks will lead the country and the markets out of a recession, though he agrees that the content of their loan portfolios holds them back. He's more optimistic about the insurers, which are trading near their long-term low price-to-book valuations.

"You would likely make very decent absolute returns over the next two to three years if you were to buy life insurance companies at book values." Mr. Graham suggests.

Ms. Shannon says investors looking for safety should consider the retailers - Canadian Tire Corp. and Empire Co., for example, are both trading with low price-to-book multiples. As for Loblaw Companies Ltd., she says the jury is still out on whether it's a value trap.

There's no question that avoiding value traps with certainty is a tough job: You have to research the company and its management well. But the crucial first step is to check the math.

Special to The Globe and Mail

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