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Cheap, safe and raring to go

Do you want a bit more zip from your value stocks? Join me as I explore a combo that might put a little more spice in your portfolio. The secret is combining the thrifty fundamentals of value investing with the price trends of momentum investing.

For value I'm going to employ a classic double-barrelled approach that has served me well for many years. Put simply, I'm looking for stocks that are both cheap and relatively safe.

On the cheap side, I want to be able to buy lots of earnings for a low price. That is, I seek stocks with low price-to-earnings ratios. While low-ratio stocks are viewed with disdain in some quarters, studies show that they tend to outperform over the long term.

Turning to the safety side of the equation, debt is critical because a profitable company with little debt is unlikely to go bust. More specifically, I opt for firms whose equity exceeds their debts.

Similarly, I also like to keep an eye on interest coverage, which indicates how easy it is for a firm to pay its debts (you can look this number up online at MSN.com). Surprisingly, using interest coverage to gauge a firm's credit worthiness yields very similar results to those offered up by the big debt rating firms. Roughly speaking, if a large stock has an interest coverage ratio higher than 2 then it probably has a BB, or better, credit rating.

Stocks should also generate healthy amounts of cash flow. Strong cash flows tend to confirm a company's earnings power and they provide some assurance that the earnings figures haven't been overly manipulated. It's not a perfect fraud detector but it is a good thing to double check.

If you think these value requirements sound strict, you'd be right. Only a few Canadian stocks managed to pass all the value tests. But now I'm going to narrow the list even more by using a dollop of wisdom from the world of technical analysis.

More specifically, I want to look for stocks trading near their 52-week highs. The idea being that while we already have cheap stocks, we also want the market to recognise them as showing signs of improvement. That way we get bargains whose prices are already on the mend. (The 52-week-range technique in discussed in more detail in A crystal ball for stocks.)

I've selected four of the most interesting candidates for your consideration from the few stocks that braved their way through both tests:

Danier Leather (DL) is at the top of my list. It's a small stock that I hold in my personal account and it is in the sometimes fickle business of selling fashionable leather coats and accessories.

Danier has something of a checkered past and I'll highlight some of its warts first. Several years ago the company tried to expand its operations into the U.S. but the effort ended in ignoble failure and a hasty retreat. The firm was also plagued by prolonged litigation related to its initial public offering, which was resolved favourably only a few years ago. To cap off the bad news, the economic slowdown of 2008-09 hit the company's profits hard because Canadians thought twice about buying new leather coats in a recession.

All the sour news pushed Danier's stock to very low levels. But the company made lemonade out of lemons and began buying back shares by the bucketful at low prices. In doing so the company managed to reduce its share count by almost 30% between 2008 and 2010. Even better, its business perked up, losses turned into profits, and its shares have climbed. The firm now trades at a price-to-earnings ratio of 9.

Breakwater Resources (BWR) is a zinc miner with operations in British Columbia, Chile and Honduras. It's also developing a new mine in Quebec, which is slated to open in 2012. While zinc is Breakwater's primary product, it also produces gold, silver, lead, and copper. Now I admit that I'm not a huge fan of resource companies because they have a tendency to gyrate wildly and lack pricing power. But Breakwater may have more than a little room to grow because it's currently trading at roughly $6, and it wasn't that long ago that it's stock was trading for more than $20. At a price-to-earnings ratio of 5, the company should do well, provided commodity prices don't collapse.

Domtar (UFS), a Fortune 500 pulp and paper firm, has significant operations in both the U.S. and Canada. The company is also the largest of the four selections, it trades at about 6 times earnings, and pays a modest 1% dividend yield.

Goodfellow (GDL) is a Canadian wood distributor hat has been on my radar for several years. Surprisingly, the firm has a reasonably consistent earnings history and has been profitable in each of the last 10 years. That's a big plus given the tumultuous times we've been living through. It also trades at 9 times earnings and provides a dividend yield near 5%, which is mighty fine because I like being paid to wait for better times.

Good luck - and, as always: Do your own due diligence before buying any stock and make sure that it's a good fit for you and your portfolio.

+ First Published: MoneySense magazine, April 2011

Correction: I look for firms with leverage ratios of 2 or less in this article. That's equivalent to looking for companies with total equity exceeding total debt.

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