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Simple stocks for a pricey market

It's amazing how quickly the mood of the market can change. Depression reigned supreme only two years ago. Back then I remember discussing the state of the markets with my friend Ian. He was gloomy. I, on the other hand, expressed reason for optimism and suggested that we might see blue skies in only a few years. But even I was shocked at the magnitude of the change.

Problem is, now the tables have turned: investors are euphoric and I'm starting to feel a little down. That doesn't mean we're on the brink of the abyss - my crystal ball is foggy on this point - but stock valuations are high compared to their historic norms. And as prices rise, the risks grow and future rewards diminish.

To help mitigate against the risk of buying expensive stocks I turn to Graham's Simple Way which seeks stocks that are both cheap and relatively safe. I've been using this approach since 2004 for MoneySense and, so far, the results have been excellent.

If you had purchased equal dollar amounts of each of our Simple Way stocks for your RRSP and rolled the profits into new Simple Way stocks, you would have enjoyed a 126% gain in 89 months (that's almost seven and a half years), not including dividends. In comparison, the S&P 500 (as represented by SPY) advanced only 14% over the same period.

On an annual basis, my Graham stock picks have climbed 11.8% on average each year, which is 10 percentage points a year more than the S&P 500's 1.8% yearly gain. That's quite good considering that we suffered through the biggest market crash since 1929 during that period.

Graham's aversion to debt, which was honed during the Great Depression, has helped us to avoid some dangerous situations. More specifically, Graham wanted his stocks to have leverage ratios (the ratio of total assets to shareholders' equity) of 2 or less. That single requirement steered us away from the many highly leveraged financial stocks that got crushed in the 2008-09 collapse.

But Graham also wanted his stocks to be cheap. He sought stocks with earnings yields at least twice as large as the average yield on long-term AAA corporate bonds. The yield on 20-year AAA U.S. corporate bonds was 5.4% when we selected this year's batch of Graham stocks. As a result, stocks currently pass the test if they have earnings yields of 10.8% or more.

When it came to selling, Graham suggested waiting for either a 50% profit or for no later than the end of the second calendar year after purchase. To make things even easier, I take the more straight-forward approach of selling the previous crop of Graham stocks whenever a new bunch is selected.

With Graham's criteria in hand, I ran a screen to produce a short list of this year's interesting candidates. I narrowed the list down by focusing on the 10 cheapest stocks in the U.S. with market capitalizations of more than $500 million. (All figures are in U.S. dollars and as of April 15, 2011.)

This year's group is fairly diverse but it seems that semiconductor companies are awfully well represented. Equipment maker Kulicke & Soffa (KLIC, $8.38) sports the highest earnings yield at 23% while Veeco Instruments (VECO, $47.50) has a middling yield of 18%. Memory-chip maker Micron Technology (MU, $10.75) has the lowest yield of the group at 14%.

I was interested to see Leucadia (LUK, $35.81) make the cut because it is run by savvy investors who have an eye for special situations. As a result, the firm is often considered a Berkshire Hathaway substitute. But, like Berkshire's Warren Buffett, Leucadia's management team is getting on in age and their pending retirement has become a real concern for investors.

The beleaguered newspaper industry makes an appearance with E. W. Scripps (SSP, $9.33). But Scripps is also into TV and other media operations which is a bonus.

Montpelier Re (MRH, $17.69) is a reinsurer which means that it provides insurance to insurance firms that want to offload risk. As a result, hurricane season tends to be a bit of a white-knuckle affair with this one.

If U.S. real estate doesn't have you totally bummed out, then building materials firm Owens Corning (OC, $36.75) might be your cup of tea. It's up nicely from its 2009 low and should do well when real estate gets going again.

The next two stocks trade on both U.S. and Canadian exchanges. Paper maker Domtar (UFS, $89.13) has been on a tear and is trading near its 52-week highs despite sporting a 15.7% earnings yield. Taseko (TGB, $5.52) makes its living from the copper, molybdenum, gold, and niobium that it mines in British Columbia.

Rounding out the list is Skechers USA (SKX, $20.38) which focuses on footwear. I admit to being a little leery about this one because shoe shoppers can be a fickle bunch. But given its low price, it might have a bit of a run left in it yet.

I have high hopes that Graham's Simple Way will continue to do well in the long run, but use it as a starting point for your research, not the final destination. Don't expect to outperform the market every year, and keep in mind that stocks are generally expensive right now, which means that earning generous returns will be an uphill battle.

+ First Published: MoneySense magazine, June 2011

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