The world's best-value stocks

Fight or flight? Investors are choosing the latter.

Dare I say it, but after months of runaway markets and profits, some complacency had set in. But the tide is turning against them. Consider:

The euro is crumbling. American stocks are following suit.

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Even the high-flying, perennial source of optimism - the Chinese stock market - is under assault. It's officially entered bear market territory, as prices recently dropped 23.3% below the November 2009 high.

The headwind has rocked investors back on their heels a bit and they're resorting to the flight instinct - into cash and (gasp) US Treasuries, of all assets. I don't recommend you join them. Instead, step up to buy Japanese small-cap stocks. Here's why.

Value investing: never en-vogue, but great during turbulence

My colleague, Alexander Green, recently discussed the 'value investing' concept. In it, he noted the work of Ben Graham and David Dodd, who argue that their method of value investing not only leads to higher returns, but also provides a "margin of safety."

However, insisting on a "margin of safety" doesn't simply mean fleeing into cash. That strategy doesn't pay - especially now. The average savings account yields a paltry 0.87%, according to Bankrate.com. Not to mention, bailing into cash requires knowing precisely when to get back into the market, which is impossible. We don't try to time the market - and neither should you.

Instead, keep this in mind: Deep value investments always perform best in the long run, based on three significant valuations:

On a price-to-earnings basis, the cheapest stocks return 16.2% per year, compared to 6.9% for the most expensive and popular stocks (i.e. - 'glamour' stocks).

On a price-to-book basis, the cheapest stocks return 16% per year, compared to 8% for glamour stocks.

On a price-to-cash flow basis, the cheapest stocks return 17% per year, compared to 8% for glamour stocks.

If you're a pessimist, or non-believer, you can check out all the hard data behind these figures at The Brandes Institute[pdf].

Now let me tell you how Japanese small-cap stocks fit into the equation...

Fire sales don't last forever

Japanese small-cap stocks are some of the cheapest in the world right now. They're trading at an historically low average price-to-book ratio of 0.86 - a 60% discount to the S&P 500. On a price-to-sales ratio basis, they're trading at a 67% discount to the S&P 500.

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Even more compelling, you can find more of Ben Graham's favorite investments - net-net stocks - in Japan than any other country in the world. I'm talking about companies that trade below their liquidation values. While the Nikkei languished for two decades, Japanese net-net stocks returned over 50%. You could have made a killing in Japan during its lost decades. All you had to do was focus on value stocks.

Net-net valuation

Created by Ben Graham, this is arguably the purest way to gauge a company's value. It basically measures a firm's value based on its current net assets. It takes all cash and cash equivalents into account, then subtracts the value of accounts receivable and reduces total inventory to liquidation-like prices. Total liabilities are then subtracted from the total net assets to produce the net-net value.

These deep, deep-value stocks boast an even more impressive long-term track record than run-of-the-mill value stocks. They returned an average of 35% per year since 1985.

And it's not hard to understand why. After all, if I offered to sell you a 100-dollar bill for 50 bucks, you'd jump at the opportunity. Cash is cash. It has a known value.

And that's what's going on in Japan at the moment. Hundreds of stocks are trading at a price-to-book value below one. And since Japanese firms love to stockpile cash, this book value is "hard" - mostly in cash.

But bargains like this don't last forever. It's only a matter of time before investors scoop them up.

Buy now... or pay more later

Japan is like the Rodney Dangerfield of the investment world - it gets no respect. Of course, its economy and stock market hasn't done much to garner a lot of respect over the past two decades. But right now, it's clearly the cheapest and safest country to invest in. There just isn't much more room for these stocks to fall.

However, there are plenty of reasons for them to jump higher.

Improving GDP numbers.

New leadership committed to economic reforms.

Recovering domestic demand.

A projected 64% jump in corporate profits.

As one fund manager reveals, "Investors still don't like Japan, but there is gentle interest and sentiment is changing." Here's a newsflash, though: The investors with that change of heart aren't lightweights.

We're talking about big names like Warren Buffett. He recently confessed that he "would like to make a large acquisition in Japan." And the famed Tweedy Browne Global Value Fund (TBGVX) just scooped up two unnamed Japanese micro-caps because the bargains were irresistible.

Such moves by these mavens often precede massive shifts in sentiment. So don't get caught off guard. The margin of safety in Japanese small-cap stocks is significant. So is the upside potential.

This article was written by Louis Basenese and was first published in the daily investment newsletter Investment U on 21 May 2010.