Three U.S. stocks Benjamin Graham probably would have loved

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John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.

Call it the revenge of the underappreciated.

A 10-stock portfolio of U.S. stocks modelled on the investment philosophy of Benjamin Graham, the "Father of Value Investing," is up 33.2 per cent this year, beating the 7.9-per-cent gain in the Standard & Poor's 500. Since 2003, the portfolio is up 345.4 per cent, and it has returned 11.8 per cent annually compared with the 6.1-per-cent return of the broad market. The value rebound is happening in Canada as well, and the Graham Canadian model I run is up 27.7 per cent so far for the year versus 15.3 per cent for the TSX. Its annualized return since 2010 is 6.0 per cent against 3.9 per cent for the Canadian benchmark.

If only it were that easy.

In a 2014 research note titled "Value Investing: Digging Manager Graveyards since 1900," Wes Gray, a U.S.-based money manager and author of the book Quantitative Value, showed just how volatile value investing can be by showing the monthly divergence of a value strategy against the S&P 500. The test, which ran back to 1963, showed significant outperformance over the market but the volatility of the portfolio and deviations from the benchmark varied largely as well. The value models we run, including the Graham portfolio, show the same pattern and understanding the nature and cyclicality of value strategies is important for any long-term investor.

Concentrating on deeply discounted stocks means not always keeping pace with what the broad market is doing because it is somewhat counter to popular opinion. The problem with value investing is the companies in question tend to have short-term issues that weigh on their stocks, enough to keep skittish investors away. Basic materials and energy stocks fall into this group and were hammered in 2014-15 as investors fled them during the collapse in commodity prices. Financials, a large cohort in many value portfolios, haven't been helped by persistently low interest rates, either. When you run concentrated value strategies, such as the Graham models mentioned above, you can be rewarded greatly during certain periods and over the long run, but investors need to be mentally prepared for volatility when value falls out of favour.

But in 2016, some investors seem to be returning to the style popularized by Mr. Graham, whose devotees include Warren Buffett. Mr. Graham believed in finding deeply discounted stocks of companies that had strong fundamentals but had been somehow overlooked by the market.

Mr. Graham knew the mental aspect of investing was equally as important as the research, which is why he drew a distinction between speculation and investment, and favoured the latter. He didn't focus on trendy stocks, instead he looked at balance sheets and income statements. One of the things he emphasized was the idea of a "margin of safety," or the difference between a company's stock price and the underlying value of its business. The bigger the difference, the more potential there was for the stock to perform well or at least not slide any further because it was already so cheap.

The idea is fairly simple: When good businesses survive a short-term challenge, their stocks usually come back strong.

Mr. Graham also believed in being conservative with taking risks. Investments weren't meant to be a quick-profit. He called it being defensive – limit risk by using several methods to evaluate a company's financials.

He believed a company's long-term debt should not be greater than its current assets. He also made sure the ratio of a company's assets to its liabilities was two or greater, a measure of good financial health.

Mr. Graham also relied on two other numbers. He looked to make sure the price of the company's stock divided by its most recent 12-month per-share profits or the average earnings over the previous three years (Mr. Graham would take the greater of the two numbers) was 15 or below. A relatively low P/E ratio reflects the market's perception that the stock is low risk or low growth or both.

And he looked to see that the price-to-book multiplied by the price-to-earnings ratio was 22 or below, an indication that the market thinks the company is undervalued relative to others. That metric doesn't work as well on companies with a high amount of intangible assets, such as Facebook and Google, but generally speaking, stocks with lower price-to-book values tend to outperform those with higher ratios.

Here are three stocks that fit Mr. Graham's investing style from the U.S. value screen:

• Dril-Quip Inc. – This Houston-based oil field services company has zero long-term debt and assets of $1-billion (U.S.). Its price-to-earnings is a comfortable 14, suggesting it is poised to grow with the recovery of the energy sector.
• Wabash National Corp. – A pickup in economic activity will benefit companies such as this Lafayette, Ind.-based maker of commercial trucking equipment, which has a low P/E of seven and earnings per share growth of 30 per cent.
• Westlake Chemical Corp. – This Houston-based maker of petrochemicals and building products has a slightly elevated P/E of 17. But its return on equity is 12 per cent, and a renewed focus on commercial activity suggests it has some room to grow.