RBC picks best value opportunities in U.S.

WHAT ARE WE LOOKING FOR?

Today marks the fourth in a series of examinations of top stock picks of various brokerage firms.

So far, the series has looked at the portfolio of 12 larger-capitalization Canadian stocks compiled by George Vasic, strategist at UBS Securities Canada Inc.

Then we checked up on the performance of the Raymond James Ltd. analysts' top picks for 2008 that were chosen in late 2007.

Yesterday, we turned to RBC Dominion Securities Inc. and chief institutional strategist Myles Zyblock's list of low-multiple Canadian stocks that he thinks offer investors opportunity from a value point of view. Mr. Zyblock has also come up with a parallel list of U.S. value opportunities, which we will look at today.

WHAT CONSTITUTES A VALUE

OPPORTUNITY?

Just buying and holding a stock with a low price/earnings multiple doesn't guarantee a superior return. Mr. Zyblock found that only about half of the stocks in a portfolio constructed solely on the basis of low P/Es fared better than the benchmark, while another 40 per cent actually continued to fall over subsequent quarters, thereby becoming what he calls a value trap.

He admits that differentiating value opportunities from value traps is difficult, but the task is made easier by examining a stock's fundamental momentum and predictability. "Our style analysis suggests that value-trap risk is highest for low P/E stocks with bottom-ranked predictability and/or momentum scores," he said in a report last week. Conversely, those low P/E stocks with a high degree of fundamental momentum and/or predictability are likely to be value opportunities.

A stock's momentum is determined by looking at the momentum of its earnings, revenue and total return as well as positive earnings estimate revisions and positive earnings surprises. Predictability is judged by the stability of total return and profit, earnings estimate confidence and low frequency of unusual items in their financial reports.

WHAT DID WE FIND?

The list of low P/E stocks with high predictability is a diverse one, with two retailers, three insurance companies, a holding company, a tobacco firm, a commercial printer, a drug company and a tool firm.

The second list - those with high fundamental momentum - is much more concentrated. Energy companies account for four of the 10. There are two offshore drillers. Again, insurance companies are a significant factor. All of the high-predictability group and all but two of the high-momentum group are down so far this year. The exceptions are insurer Safeco Corp. and offshore drilling firm Ensco International Inc. Gains in both cases were substantial. Transocean Inc. is down just 0.9 per cent on the year.

SOURCE: GLOBE INVESTOR, RBC