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Is Mr. Market off his meds?

The market often behaves like a deranged manic-depressive and it was clearly off its meds this year. Just last winter it was in a deep funk, and panicky investors couldn't sell fast enough. Then all of a sudden, the gloom vanished, the market reversed course, and it shot skyward. It's all a bit zany. But how should you deal with such massive market swings?

Benjamin Graham had the answer. You should help out manic-depressive investors. Buy when they rush to sell. Sell when they line up to buy. That's why I suggested that it was a good time to buy stocks in MoneySense last February. As it happens, my timing was dead on, because the market hit bottom in March and it's climbed smartly since then. Today's higher prices also mean that I'm now more cautious on the markets than I was in the spring.

But I'm still keen on individual stocks. To find interesting candidates I turn to Graham's Simple Way. So far, the results have been good. If you had purchased equal dollar amounts of each Simple Way stock for your RRSP and rolled the profits into new Simple Way stocks every year, you would have enjoyed a 45% gain in 70 months, not including dividends. Over the same period, the S&P500 dropped 8%.

I regularly track Graham-inspired techniques for clients and, at the start of March, I reformed the Simple Way portflio. You'd have done well to buy in the spring because the new portfolio was up 73.4%, not including dividends, by the start of October. So, while Graham's stocks got beaten up with the rest of the market last fall, they also snapped back swiftly.

Graham's aversion to debt helped investors avoid dangerous situations over the last few years. More specifically, Graham wanted his stocks to have leverage ratios (the ratio of total assets to shareholders' equity) of two or less. That single requirement steered investors away from highly leveraged banks and other financial stocks which got crushed in the collapse.

Graham also wanted his Simple Way 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 5.22% when we selected this year's batch of Graham stocks. So, stocks pass the test if they have earnings yields of 10.44% 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 straightforward approach of selling the previous crop of Graham stocks whenever a new bunch is selected.

With Graham's criteria in hand, I useda stock screener to find a short list of 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 October 2.)

The 2009 bargain bin contains three heath-care stocks. Offering the highest earnings yields are Gentiva Health Services (GTIV, $24.18), which provides home nursing, and biotech firm OSI Pharmaceuticals (OSIP, $34.16), which focuses on cancer, diabetes and obesity drugs. Offering a slightly lower earnings yield is Healthspring (HS, $12.15), which specializes in managed care for Medicare patients in the U.S.

Oil & gas contract drillers, and offshore support service firms, are also well represented on this year's list. Noble (NE, $36.15), Rowan (RDC, $21.63), and Ensco (ESV, $40.00) all drill for crude offshore. Noble happens to be the largest Graham stock this year with a market capitalization of $9.8 billion. Ensco and Rowan are the second- and third-largest respectively. Tidewater (TDW, $45.27) and GulfMark (GLF, $31.21) are in the related business of providing vessels and marine support services to the energy industry.

Moving away from bubbly crude, CNA Surety (SUR, $16.16) provides commercial and contract surety bonds throughout the United States. Finally, in a blast from the Internet past, EarthLink (ELNK, $8.47) rounds out the Top 10 list. While it isn't a growth story, the company provides legacy dial-up Internet connections to consumers, sports a 6.6% dividend yield, and a strong balance sheet.

I have high hopes that Graham's Simple Way will continue to do well in the long run, but all the usual warnings apply. Use Graham's list as a starting point for further research and not the final destination. Don't expect to outperform the market each and every year. And keep in mind that we've already seen a big bounce, so the bargains are starting to disappear.

From the November 2009 issue of MoneySense magazine

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