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ian mcgugan

The toughest thing to find in today's stock market is a bargain. After one of the longest bull runs in investing history, many assets look generously, if not extravagantly, valued.

But there are exceptions. Look beyond the trendy FANG shares – Facebook Inc., Amazon.com Inc., Netflix Inc. and Alphabet Inc. (parent of Google) – and you'll find several stocks, ranging from banks to miners, that are trading at valuations that appear quite reasonable.

That doesn't mean these stocks are guaranteed to deliver big gains. Many are cheap for excellent reasons. But they do merit further research. Given any pleasant surprises, they have the potential to increase in price in a way that their already expensive cousins don't.

In fact, all that would be required for many of today's cheap stocks to shine would be a reversion to the mean. Over the past five years, the S&P 500 value index, a collection of large U.S. stocks trading at low multiples of their earnings, sales and book values, has lagged the broader market by about 1.5 percentage points a year. If the pattern reverses, value hunters will beat the market in coming years.

So how should you begin your search for potential bargains? Here are three strategies.

By the numbers

The time-honoured way to search for value is to look for companies trading at low multiples of their earnings, sales and book value.

None of these measures is infallible, but taken together they can help suggest which sectors are pricey and which ones aren't.

Right now, for instance, it's clear that the market has built huge expectations around stocks such as Facebook and Amazon. They trade at lush to stratospheric valuations – 34 times profits in the case of Facebook, nearly 300 times earnings in the case of Amazon.

In contrast, a number of sectors are either ignored or actively disliked. Many retailers, for instance, are loathed given the general assumption that Amazon will soon be selling everything to everybody.

Target Corp., which was a hot stock only a few years ago, now changes hands for a mere 13 times earnings. Foot Locker Inc. is even cheaper at only 10 times profits. In Canada, the grocer Metro Inc. goes for around 16 times earnings, as does Canadian Tire Corp. Ltd.

Risk takers may want to prowl through this heap of unliked retail stocks on the chance that some of this year's trash will turn out to be next year's treasure. Such a turnaround has precedent. Wal-Mart Stores Inc. soared 41 per cent this year on growing evidence that it will be able to grow its own e-commerce business. In Canada, Dollarama Inc. has jumped 58 per cent since the start of the year as the discount retailer continues to produce strong numbers. It's proof that even in an age of Amazon, storekeepers with the right formula can be good investments.

If retailers aren't enough to get your pulse racing, thrill seekers may also want to consider car makers. Ford Motor Co. and General Motors Co. are both cheap on metrics such as price-to-earnings and price-to-book ratios.

Canadian and U.S. Stocks

Canadian StocksTickerPrice-to-Earnings RatioPrice-to-Book RatioPrice-to-Sales Ratio
Canadian Tire Corp. Ltd.CTC.A-T16.02.30.9
Cenovus Energy Inc.CVE-T11.00.50.8
Goldcorp Inc.G-T29.60.83.1
Metro Inc.MRU-T15.83.20.7
Teck Resources Ltd.TECK.B-T6.30.91.4
U.S. Stocks
AIG Inc.AIG-Nn/a0.71.1
Assured Guaranty Ltd.AGO-N7.00.62.3
Citigroup Inc.C-N14.21.02.4
Foot Locker Inc.FL-N10.22.00.7
Ford Motor Co.F-N7.51.50.3
General Motors Co.GM-N6.81.40.4

Bloomberg

Data as of Nov. 30, 2017. 

To be sure, car companies often trade at low multiples. Their low valuations are understandable given the auto industry's cyclical nature, high debt levels and miserable history of creating value, as well as the potential disruptions that loom ahead from self-driving technology and electric vehicles. Still, there may be at least a bit of hidden value here.

When shares are trading hands for less than eight times earnings, as both Ford's and GM's are, they don't have to do a lot to exceed market expectations. That's one reason why GM shares are up 22 per cent this year while even Ford stock has gained 4.8 per cent.

Say what you will about these rust-belt relics, but as newcomers such as Tesla Inc. confront production problems, the ability to consistently churn out huge numbers of cars could start to garner new respect.

If car makers get little respect, so do many commodity producers. In Canada, a cluster of miners and oil companies – Cenovus Energy Inc., Goldcorp Inc. and Teck Resources Ltd. – look cheap, especially when measured against their book values (the difference between the value of assets and liabilities on the balance sheet). In the United States, it's financial services giants that stand out on the same score. Citigroup Inc. and insurer AIG Inc. both trade at or below their book value.

Some smaller sectors also deserve investigation. Monoline insurers – the folks, such as Assured Guaranty Ltd. and MBIA Inc., who insure municipal bonds and similar offerings – are selling well below their book values. The big worry is that they will be crushed by their guarantees on Puerto Rico's bonds. But at least some analysts believe they'll be able to survive and even prosper.

If monolines and car companies are too risky for your stomach, the simplest strategy of all for those who want broad U.S. exposure would be to invest in a value-oriented exchange-traded fund (ETF) such as the iShares S&P 500 Value Index ETF. This gives you a wide selection of unloved stocks trading at low multiples of their earnings, revenue and book value.

Listen to the experts

The most common criticism of choosing stocks by the numbers is that the numbers sometimes hide or lag reality. As a result, many investors place great weight on analysts' opinions.

This, to be sure, is a debatable strategy. Analysts' calls can be distorted by factors such as a desire to maintain access to company management and to support their employer's investment-banking business. For whatever reason, analysts tend to be an optimistic bunch. Still, it's interesting to see what analysts think about a potential investment. They can help point out factors you haven't considered.

It's especially intriguing to look for companies that meet traditional value criteria, such as low price-to-book value, and also earn applause from analysts.

For instance, a simple screen of the S&P/TSX composite index for companies with market capitalizations of more than $5-billion, trading below their book value, but with the equivalent of a consensus "buy" rating from analysts turns up a cluster of resource names such as Goldcorp, Teck, First Quantum Minerals Ltd. and Tourmaline Oil Corp., as well as Brookfield Property Partners. If nothing else, the list suggests that there may be more value in certain corners of the mining and oil industries than the market is currently recognizing.

Another way to tap analysts' opinions is to look for stocks with ugly fundamentals but positive recommendations from analysts. The idea here is that if Bay Street is still upbeat about a stock despite a lack of obvious fundamentals, then there may be positives the numbers don't reveal. This could be a sign of frothiness, but it may also point to opportunity.

One name that pops up in this regard is Ivanhoe Mines Ltd., the latest vehicle of mining promoter Robert Friedland. The company has no earnings but still garners high recommendations from analysts because of what appear to be promising projects in development. The catch – and it's a big one – is that the projects are in politically volatile nations, notably the Democratic Republic of the Congo. There are obviously huge risks in investing in Ivanhoe, but analysts tend to believe the payoff will be worth it.

Search globally

Stock picking has its charms, but most academics will tell you that stock prices in most markets already reflect just about every scrap of available information, making superior performance extremely difficult to achieve. History certainly shows that it's difficult for any stock picker to consistently beat the market index over the long haul.

So maybe the thing to do is to stop picking individual stocks and instead pick broad markets that look to be well priced for gains. One relatively straightforward way to do this is to look at different countries' stock markets and pick the ones that are cheapest.

A convenient metric for making your selection is the cyclically adjusted price-to-earnings (CAPE) ratio popularized by Nobel economics laureate Robert Shiller. It looks at how current share prices compare with average corporate earnings over the past decade. CAPE, at least in theory, smooths out the ups and downs of the business cycle to show you how any stock market stacks up against the baseline earnings power of its underlying companies.

CAPE Ratios

CountryCAPE ratio *
Russia5.6
Brazil12.4
South Korea15.3
Britain15.7
China17.3
Australia17.3
Germany20.4
India20.9
Canada21.2
United States29

Star Capital

Cyclically adjusted price-to-earnings ratio as of Sept. 30, 2017.

By this measure, U.S. stocks, with a CAPE around 30, are more expensive than they have been at any time other than during the dot-com bubble or in the run-up to the Great Depression. Canadian stocks, with a CAPE around 21, also look pricey compared with their own past.

Other markets look considerably cheaper. In particular, emerging markets, with a CAPE just over 16, seem well positioned to deliver much better returns than most developed markets.

If so, the next decade could reverse the experience of the past 10 years. From the 2007 financial crisis onward, U.S. stocks were the world's big winners. Over the course of the decade, the S&P 500 delivered a total return of more than 11 per cent a year in Canadian dollar terms.

Canadian stocks, in contrast, produced total returns of less than 5 per cent a year, while European and Asian stocks fared even worse.

The financial models developed by Research Affiliates LLC, an asset allocation firm in Newport Beach, Calif., suggest this pattern will flip in years to come.

By its calculations, U.S. stocks are going to produce after-inflation returns of next to zero over the decade to come, while European, Asian and emerging stocks will generate annual real payoffs of 4 per cent or more. (All calculations in U.S. dollar terms.)

Emerging markets have had a particularly good run lately, but bargain-hunting investors still see a lot of merit in them. GMO LLC, a Boston-based money manager, declared this summer that value stocks in emerging markets still look "a lot better than anything else."

If the notion of hunting for value in developing nations sounds appealing, you may want to take a look at exchange-traded funds that hunt in this area.

FlexShares Morningstar Emerging Markets Factor Tilt Index Fund (TLTE-NYSE) and Schwab Fundamental Emerging Markets Large Company Index ETF (FNDE-NYSE) are two tempting possibilities in a world where most assets look decidedly more expensive.