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Three stocks to watch for investors awaiting value’s return

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.

Technology stocks commanded the headlines this year until September, when out-of-favour stocks in the financial and health-care sectors heated up and people started talking about the return of the reflation trade.

You may remember this from late last year, when investors were betting on deregulation and infrastructure spending to fuel global growth, egged on by central banks.

The idea lost momentum in the spring, when the promised changes didn't happen immediately, but new talk about tax cuts in Washington has breathed new life into the trade.

Some strategists are betting on a turning point.

Part of it could be gravitational forces in the market. High-flying tech stocks seem poised to let out some steam – indeed they already have – while beaten-down stocks in other sectors appear poised to rebound.

The iShares exchange-traded fund tracking the growth index is up 18 per cent year to date, but has cooled off, up just 1.24 per cent over the past month.

Meanwhile, the iShares ETF tracking value, while up only 7.5 per cent year to date, is up 3.23 in the past one-month period.

That is sure to warm the hearts of die-hard value investors, who have been suffering for the past few years on a wave of growth-stock dominance. As top value investors will say: "Investors tend to exaggerate the attractiveness of some stocks and underestimate others, often at their expense. And it's only a matter of time until the shift occurs."

Columbia University professor Kent Daniel recently did an analysis of stock prices as they related to book value.

In the study, which he did for MarketWatch, he found that the average large-cap value stock's price-to-book ratio is half that of the average of large-cap growth stocks.

The differential is even greater for small-cap stocks. And he found the difference is wider than the average over time.

Since 1959, the average value stock's price-to-book ratio has been only a third less than that of the average growth stock, according to a recent MarketWatch column.

The late 1990s Internet-stock bubble was the only other time when value was cheaper than now.

Some people criticize the price-to-book measurement because companies are typically evaluated by the amount of profit they can generate and not the value of the assets they own. But Benjamin Graham used it as one of his stock evaluation criteria, figuring a stock selling at or below its book value was a bargain.

Joseph Piotroski, a professor of accounting at Stanford, would flip the metric on its head, and look at the book value as it related to the share price, keying in on stocks that end up in the top 20 per cent.

Then there is the price-to-earnings ratio, a measure of how much investors are willing to pay for returns. A low P/E signals very low expectations.

John Neff, the former Vanguard Windsor Fund manager who amassed a massive 30-year track record of market outperformance, used low P/Es to look for undervalued stocks.

Mr. Neff would typically seek stocks with P/Es that were about half what the market average was at any given time and then within that group he'd look for companies with steady, but not crazy, growth in earnings per share and solid dividends.

This last part – dividends – was important because even if a stock stayed cheap, the investor was benefiting from a higher than average yield.

From there he would measure total return, which he calculated as EPS growth plus the dividend yield divided by the P/E ratio. Mr. Neff used this not-so-common criteria to further narrow down the field of stocks to those that had a figured that was double the market or industry average.

Thus, he was truly following the path least trodden.

At Validea, we have a model portfolio that seeks to capture this low-P/E style of investing. Below are three of the model's current picks. Investors betting on value's turn maybe be well served looking at highly discounted stocks such as these.

Penske Automotive (PAG)

The current market average P/E is 21, and Penske's is 11.4.

The car and truck dealership has long-term EPS growth of 15.3 per cent.

B. Riley Financial (RILY)

This is an independent investment bank that has a P/E of 8.78 per cent and its EPS growth rate is 10 per cent based on the average of three-, four- and five-year trends.

Its total return to P/E is 1.39, more than double the market average.

CVS Health (CVS)

The pharmacy chain doesn't quite pass Mr. Neff's low-P/E screen, a result of its P/E of 16 and above the threshold Mr. Neff would consider the absolute sweets spot for value.

But, the stock yields nice, 2.5-per-cent passes all of the other Neff-inspired investment criteria.

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