My Top 2 Picks From A Legendary Value Investor

By (Michael Carr),

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Successful value investors often work in relative obscurity, delivering steady, market-beating returns over decades.

Jeremy Grantham is an investor that has been following a value approach to the markets since at least 1977, when he co-founded global investment management firm GMO. Over the years, GMO has grown to manage more than $100 billion in assets but is still relatively unknown.

Grantham applies a classic Graham and Dodd value approach to the markets. Benjamin Graham and David Dodd wrote the original textbook on value investing, Security Analysis , in the 1930s. Warren Buffett would later study under Graham.

And while countless investors have read the original and revised editions of Security Analysis , only a few have mastered the concepts. The very best value investors, a group that includes Buffett and Grantham, add a unique perspective to their study.

In the case of Grantham, his success is at least partly due to his ability to spot bubbles. He may know more about bubbles than any other investor. In a recent letter to investors, Grantham wrote, "We have studied more or less all assets for as long as we can find data, and we have found a remarkable total of 330 'bubbles,' 36 of which we call 'major, important bubbles,' which we define as 2-standard-deviation events."

Grantham used his knowledge of bubbles to deliver gains to his investors when the Internet bubble was bursting in 2000 and 2001. He also lost less than the market in 2008 as the housing bubble burst.

In addition to studying bubbles, GMO develops forecasts for asset classes based on its studies of long-term value. Right now, Grantham is most bullish on stocks in emerging markets, which he expects to provide average annual gains of 6.8%, after inflation, over the next seven years. In the U.S., Grantham's firm sees average annual losses of 2.1% in large-cap stocks and 3.5% in small-cap stocks over the next seven years.

In studying Grantham and other great investors, I learned that the biggest stock market winners have solid fundamentals and strong technicals. I combined these factors into a model that finds market-leading stocks with the fastest growth in cash flow. When applying this system to Grantham's stocks, two buys jumped out.

Given his outlook that emerging markets will provide the largest gains in the long term, it is not surprising to see that two of his largest holdings are in emerging markets. It might be surprising to see an Internet company on the list, but that shows Grantham invests in value, in no matter what sector he finds it.

Yandex (Nasdaq: YNDX) is Russia's largest search engine, with about 60% of the market. Over the past five years, YNDX has reported average sales growth of 46.6% and an average increase of 39.5% in earnings per share ( EPS ). Free cash flow turned positive in 2008 and has grown from $0.15 a share to $0.74, an average growth rate of 37.6% a year.

In 2012, YNDX reported EPS of $0.82 and is expected to earn $1.12 in 2013. In 2014, analysts expect EPS of $1.43. After that, analysts expect EPS growth to average 29.5% a year in the next five years. Using 2014 estimated earnings, the stock trades at a P/E ratio of 24.

The PEG ratio compares the P/E ratio to the expected EPS growth rate, and YNDX has a PEG ratio of 0.81. The PEG ratio should be 1 for a stock that is fairly valued. This measure shows that YNDX is undervalued.

Copa Holdings ( CPA ) is also undervalued with a PEG ratio of 0.53. Copa Holdings provides airline passenger and cargo services within Colombia and international flights from various cities in Colombia to Panama, Venezuela, Ecuador, Mexico, Cuba, Guatemala and Costa Rica.

Over the past five years, sales growth has averaged 17% a year, EPS grew an average of 14.7% a year, and free cash flow growth averaged 30.1% a year. Analysts expect earnings growth of 26.3% a year on average for the next five years. Based on 2014 EPS estimates, CPA could be worth more than $300 a share, more than double its recent price.

CPA has been profitable every year since 2006, including the global recession years of 2008 and 2009, when large U.S. airlines like United Continental Holdings ( UAL ) and Delta Air Lines ( DAL ) reported large losses.

Grantham has found winning stocks in the past, and equally important, he has avoided many of the large losses of the past. Most investors would not hunt for value in Russia and Columbia, but Grantham knows that successful investing requires hard work. He now holds YNDX and CPA, stocks which my system also highlights as potential winners.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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This article appears in: Investing , Investing Ideas , Stocks
Referenced Stocks: CPA , DAL , EPS , UAL

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