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Key lessons for becoming a successful value investor

Being more knowledgeable about A trade than the counterparty is a big advantage. That’s why some long-term value investors believe specialization is the best approach.

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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.

A few months ago, many people believed the stock market was overheating, yet the indexes have continued their march to record highs despite increasing uncertainty over U.S. tax reform, deregulation and infrastructure spending.

Some worried this year's gains were not broad-based, driven by just a handful of big technology stocks – Amazon, Facebook, Alphabet and Netflix – which helped skew the indexes higher.

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But the worry has started to subside. Nobel Prize-winning economist Robert Shiller said on television last week that the market seems poised to rise, especially if the promise of corporate tax cuts and economic growth comes to fruition. He pointed out that his cyclically adjusted price-to-earnings ratio is at 30 now. In the 1990s, that number went from 30 to 45, and he said stocks are more likely to go up than down over the next decade.

Echoing that sentiment, Wharton School professor Jeremy Siegel said last week the stock market was "fairly valued" and not in danger of overheating. He said momentum stocks aren't driving the indexes the same way they did in the run up to the dot-com bubble in the late 1990s.

Several factors are leading to higher valuations, according to GMO co-founder Jeremy Grantham, including higher corporate profit, and those show no signs of abating. Globalization, low interest rates and lower oil and fuel prices are boosting U.S. profits. Lower corporate taxes and less regulation could help sustain these trends. Mr. Grantham concluded in a recent Barron's interview that corporate margins will hold up, and consequently so will markets, until at least later in the year.

Ferret out information

If these expectations become reality, it will become all the more important to hunt for value. This becomes more difficult when everyone seems to be chasing the same objective. Value investors try to find hidden gems among the thousands of stocks that trade on a daily basis. True to human nature, people usually are pleased with their choices, confident they are correct even though there is another person on the other side of the transaction who probably also believes his or her strategy is the best one. But being more knowledgeable about the trade than the counterparty is a big advantage.

That's why some long-term value investors believe specialization is the best approach. Columbia Business School professor Bruce Greenwald said he advises students to specialize when they start out and gradually add to and expand that knowledge base.

Benjamin Graham, whom many consider to be the grandfather of value investing, started out specializing in railways. Specialization has benefited long-time successful value investors since then, allowing them to develop an expertise that helps them ferret out information that might otherwise be overlooked by less experienced investors.

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That, of course, is the trick to value investing – poking around among the stocks that no one wants to find those hidden gems. The markets tend to exaggerate the value of glamour stocks and undervalue others.

Successful value investors also focus on a company's balance sheet rather than relying on estimates of future cash flows, which can be flawed. A balance sheet provides some key clues about a company, including its liquidation value and its ability to generate profit. If a company's assets are worth less than its earnings power and that trend is sustainable, that is a potentially profitable investment. From there, value investors such as Warren Buffett apply different filters, including the company's competitive advantage, brand and the industry's barriers to entry.

Prof. Greenwald's advice for investors is to take advantage of a trend that isn't well understood. Look for disruptors. In the tech sector, that's easy to do. But what about the more mundane manufacturing sector? Trade is falling, and though companies in the United States are expanding, they aren't adding jobs. He says look for manufacturing-like companies that dominate their local markets and have big and expanding service components. That is the type of specialized knowledge and advice that makes value gurus such as Mr. Buffett hard to beat.

Using the Ben Graham stock screen on Validea Canada, I identified a handful of top scoring stocks. The methodology, which was extracted from Mr. Graham's The Intelligent Investor, looks for stocks with low valuations, using the price-to-book and price-to-earnings ratios, along with low debt and solid long-term earnings growth.

Senvest Capital Inc. (SEC): The Montreal-based firm operates in a number of business lines, including merchant banking, asset management, real estate, printing and electronic security. Currently, Validea's Graham-based model gives the stock an 86 out of 100 score.

Canfor Pulp Products Inc. (CFX): The stock of the Vancouver-based pulp-and-paper company (market cap $830-million) carries a reasonable P/E of 14.5 and a low price-to-sales ratio.

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Western Forest Products Inc. (WEF): The forest products company, also headquartered in Vancouver, scores highly based on a combination of value and growth models.

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About the Author

John Reese is CEO 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. More

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