Looking to 2009 laggards for next year's leaders

John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds offered in the Canadian market through National Bank Securities.

While some of the market's top strategists continue to debate whether stocks as a group are overvalued or undervalued, one thing most everyone can agree on is that valuations are not as eye-popping as they were earlier this year.

Back in March, the S&P 500's 10-year price-to-earnings ratio fell to 13.32 - its lowest level in more than two decades. Now, that figure is back up close to 20, above the historical average of about 16, thanks to the market's swift rebound.

But while the tide from that rebound has lifted most boats, it hasn't lifted them equally. Some U.S. sectors, like financials (up about 140 per cent), and basic materials and industrials (both up about 75 per cent) have really surged since the March 9 low; others - including utilities (up 29 per cent), health care (up 31 per cent) and consumer staples (up 34 per cent) - have significantly lagged the broader market. (These figures are based on SPDR U.S. sector exchange traded funds).

The lagging returns mean those sectors are now selling at some of the lower valuations in the market. Some, like health care (12.25 sector P/E) and consumer staples (14.28 P/E), are cheap largely because of fears (fear of reform for the former, fear of meagre consumer spending for the latter). Others, like utilities (12.26 P/E), have been passed over as investors look for higher growth options as the recession wanes. Whatever the reasons, these areas are now offering some attractive pockets of value in a market that is up 60 per cent off its lows. That makes them places value investors, who look for stocks trading at a discount to their underlying value, might want to look as we head toward 2010.

Keep in mind that in terms of sectors, quick leadership shuffles aren't infrequent. In 2008, materials were the second-worst performing sector; this year, they rank second best. In 2006/2007, financials went from second best to worst. And between 1999 and 2000, the best-performing and worst-performing sectors flip-flopped, with technology going from first to worst, and consumer staples doing the opposite.

While those were all periods of major market turning points or turmoil, the same often occurs when the market is generally moving in one direction. In 2005/2006, for example, consumer discretionary went from worst to third best, and in 2004/2005 health care did the same (both during a bull market). And in the middle of a bear market, energy stocks went from second worst in 2001 to third best in 2002.

With all of that in mind, I recently searched for bargains in the utility, health care, and consumer staples sectors using my Guru Strategies, computer models each based on the approach of a different investing great. Here are some of the best of the bunch:

CVS Caremark Corp.

This pharmacy chain crosses over two of the recent laggard categories - consumer staples and health care. My Peter Lynch-based model is high on the stock because of its solid 0.86 P/E/Growth ratio (which divides a stock's price/earnings ratio by its growth rate, adjusting for yield in the case of large "stalwarts" like CVS). That's a sign the stock is a bargain at its current price. My Lynch-based model also likes CVS's 30.5-per-cent debt/equity ratio.

Southern Union Co.

Southern Union is a natural gas utility that has about 20,000 miles worth of pipeline in the U.S. The $2.6-billion (U.S.) market cap firm is another favourite of my Lynch-based model, which likes its strong 26.4-per-cent long-term earnings growth rate and 10.9 P/E ratio. Those figures make for a P/E/G of just 0.41, which falls into this model's best-case category (below 0.5).

Endo Pharmaceuticals

Endo, whose products are used to help with pain, overactive bladder, prostate cancer and the early onset of puberty in children, is a favourite of the model I base on the writings of hedge fund guru Joel Greenblatt. The model likes the $2.8-billion market cap, Pennsylvania-based firm's return on total capital of 42.3 per cent and earnings yield of almost 15 per cent, and rates it the 31st best stock in the market.

Endo also gets high marks from my Lynch-based model, thanks to its solid 0.64 P/E/G ratio and manageable 33.8 per cent debt/equity ratio.

Embotelladora Andina S.A.

This Chile-based consumer staples firm bottles and distributes Coca-Cola products in Chile, Brazil, and Argentina, and gets approval from two of my models. My James O'Shaughnessy-based growth model likes that Andina has upped EPS for five consecutive years. It also likes its combination of a low price/sales ratio (1.32) and high relative strength (81), which indicates that the stock is hot but hasn't become overvalued.

My Lynch-based model also likes the $2-billion market cap firm because of its stellar 0.51 P/E/G ratio and 25 per cent debt/equity ratio.

At the time of publication, John Reese was long CVS and ENDP.