I’m buying because I know that fear and panic are recurring, but temporary, features of Bay Street and Wall Street. I’m confident that the current mess, both in the markets and in the economy, will eventually clear. Recovery may take a while, but just as good times inevitably come to an end, so do bad times. And when the current crisis eases, I expect my current purchases to do very well.

I’m not trying to brush off the pain that many investors are feeling today — U.S. and Canadian stocks are down about 41% from their respective peaks. I can sympathize with anyone who has seen the value of their investments chopped nearly in half. There might even be more suffering ahead before the market turns decisively upward. But let’s put the decline into context. The current downturn is big, but not unprecedented—in fact, based on monthly data, it’s only the fourth worst market slide since 1876.

History suggests that bear markets tend to recover relatively quickly. U.S. markets typically recover all their losses within 31 months after hitting bottom. (The historical data, which includes reinvested dividends, are based on month-end figures for the S&P 500 and its predecessor indexes produced by Robert Shiller, a professor of economics at Yale.)

How bad can things get? The great crash of 1929 saw U.S. stocks slide 83% over 33 months. Even more depressing, it took until 1945 for them to climb back to their former levels. There is a slim (I think very slim) chance that the current downturn may rival that record, so it is wise to make sure that you can survive further declines should they occur. But for the most part the historical record gives us more reason for optimism than pessimism.

The greatest reason for optimism is that stocks are now offering some of the best values in more than a decade. Many quality companies are available at sharp discounts. Second-tier firms are going for a song. Charlie Munger, the U.S. billionaire, says, “Price is what you pay, value is what you get.” The value indicators I see say that this is the best time to buy since the early 1990s.

One good measuring tool is the trailing 10-year P/E ratio on the S&P 500 index of large U.S. stocks. This ratio works much like a regular price-to-earnings ratio, but instead of comparing a company’s stock price to its earnings over the past 12 months, it compares the firm’s stock price to its average earnings over the past 10 years. By looking at 10-year average earnings, rather than just the past year, you smooth out the ups and downs of the business cycle.

The 10-year P/E ratio is now below its median level. This indicates that for the first time since the early 1990s, U.S. stocks are no longer wildly overpriced. Instead, they offer fair value and should produce profits in keeping with the stock market’s long-term record. That means it’s reasonable to expect returns approaching 10% a year, or more, from stocks over the next decade or so.

Canadian companies also appear to be on sale. You can see this if you look at the Canadian stock market’s price-to-book value ratio. Book value is the amount of money that you would obtain if you could sell off all of a company’s assets (at their balance sheet values) and pay off all of its debts. Most of the time stocks trade at a premium price compared to their book value because they’re worth more alive than liquidated. Today, that price-to-book-value premium is much reduced. I only have data for a comparatively short period, but the numbers show the S&P/TSX composite is less expensive than it has been in more than a decade.

I acknowledge that you can interpret my charts in a couple of ways. While stocks are now at fair levels, you can see that they’ve been even better bargains at several points in the past. So, yes, there is a possibility that stocks could fall further and you should be prepared for that eventuality. The dilemma is, should we take a chance and hope for even better bargains ahead, or accept the pretty good deals that are already on offer?

There’s a fellow in Omaha who recently spoke to that question. His name is Warren Buffett and he is very optimistic. In October, he wrote an article for The New York Times called “Buy American. I Am.” Buffett declared that he was moving his personal portfolio from government bonds to stocks and expected to soon be fully invested in U.S. stocks. “A simple rule dictates my buying,” Buffett wrote. “Be fearful when others are greedy, and be greedy when others are fearful…I haven’t the faintest idea as to whether stocks will be higher or lower a month—or a year—from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

Buffett doesn’t often make public calls on the stock market, but the billionaire’s past pronouncements have been very profitable. He was a vocal advocate of buying stocks at a couple of points in the 1970s; then, at the height of the tech bubble in 1999, he went public to warn people away from stocks. You would have done well to listen to the Oracle of Omaha. Like Buffett, I expect stock market returns over the longer term to be quite satisfactory. I think now is a good time to put some money to work.

I can hear your protests from here. If you’re having difficulty grappling with the notion of pouring more spare cash into the stock market after the disaster of the past year, I sympathize with how you feel. But you should remind yourself that emotions often lead us astray, particularly when it comes to the stock market. No matter what you decide to do over the next few months, you can take away a profitable lesson from this crisis if you realize that it is important to break away from the herd when it is stampeding over a cliff.

Most investors sabotage their results by buying after long periods of prosperity when the market is at a high, and selling—or at least, refusing to invest—after periods of hardship when the market is significantly down. This habit of buying high and selling low meansmost investors do much worse than the overall market. Consider the Vanguard Total Stock Market Index Fund. This index fund posted average losses of 0.7% a year for the 10 years ending Dec. 31, 2008. However, the typical investor in the fund actually lost 3.7% a year over the same period, according to morningstar.com. The difference—a whopping three percentage points a year—is the result of investors jumping in and out of the fund at bad times. Similar results have been found by numerous studies that try to measure the impact of investors’ timing on their portfolio results.

It feels scary to invest in the market during a recession. Friends and family won’t pat you on the back and reassure you that you’re making the right move. But if you diversify your holdings and do your research, I think the market holds more potential now than it has for a decade. As a result, I’ve bought more shares in the last few months than I have over the last few years and I’m keeping some cash on hand to buy even more should further opportunities arise.

I think those who buy stocks now will do well—but be honest with yourself. If you are a dyed-in-the-wool GIC investor, you probably shouldn’t swap your GICs for a stock-heavy portfolio. In fact, people who don’t like risk should steer clear of stocks no matter how tempting the current valuations may be. Just remember to stick to that habit the next time that a bull market is in full swing.

Given current valuations, I believe that you are likely to make money in the long run on almost any equity fund that you buy now. And if you can find yourself a downtrodden fund that has temporarily underperformed its peers, you might be able to do even better. In saying this, I am not predicting that the bear market will end tomorrow. The financial crisis rocking the world is by far the worst that we have seen since the Great Depression. How long it will last, or how much further pain will be involved, is anybody’s guess.

But I do think that many stocks are selling for tempting prices. No matter which metric you examine — price-to-earnings, price-to-book, price-to-sales — you can find dozens of solid companies selling for prices that would have been considered unbelievably low a year ago. These stocks may stay cheap for a while, but in the long run, they should provide you with a good return.

I know it takes courage to keep your money at risk in these volatile markets. It’s tempting to get your cash out now, and plan to jump back into the market in a year or two, when things will presumably be less chaotic. I wouldn’t recommend this manoeuvre, though. Market timing is likely to hurt you in the long term, because you won’t know when to get back in. You are almost guaranteed to miss the beginnings of the next upswing.

A smarter strategy is to minimize your risk of loss by investing in battered mutual funds that are likely to lose less than the market if the crisis continues and gain more than the market when the turmoil finally ends. The idea in picking these funds is to ride the ups and downs of what academics call “reversion to the mean.” This is the tendency of any volatile process to go through periods of unusual highs or lows, but eventually come back to its long-run average.

In the world of mutual funds, reversion to the mean implies that good fund managers often have periods of poor performance followed by periods of superior performance. So at times like this you should identify funds that have underperformed in the past year or two for reasons that you think are temporary. As long as the manager remains at the helm, and stays faithful to his or her style and portfolio focus, you should be able to expect much better times ahead.

The trick, of course, is to understand the factors behind the recent weakness and make sure that these factors are temporary, not permanent. Permanent weaknesses would include an unreasonably high management fee, or a flawed investment approach that has consistently delivered poor returns both in good and bad times.

Trying to select funds ready to rebound is not a straightforward exercise. I’ve scoured my database and come up with only six funds that I think fit the bill.

Mackenzie Cundill Value Fund is headed by Peter Cundill, a manager with an excellent long-term record. The fund has lagged the market recently, in large part because of its low exposure to oil and other commodities. That said, this is a fund that sticks to a philosophy of buying bargain stocks on the cheap and that operates with an investment horizon of three to five years. I think it is well suited to patient investors. Drawbacks? I do not like the fund’s large size (more than $6 billion in assets), because it’s difficult to be nimble when you have to put large amounts of cash to work.

Brandes Global Equity has lost 25% of its value in the past year, mostly because of its high concentration on financial stocks, which have been hammered by the recent crisis. But the fund’s bold approach has delivered good results in the past and I have no reason to doubt its ability to repeat its past successes when the tide turns in its favor. Just remember: this is a fund that will experience big ups and big downs. Invest only if you have a healthy appetite for risk.

PH&N Dividend Income has trailed its peers in recent months because of its hefty holdings of financial stocks and its relative lack of energy stocks. But I’m not too worried by its sluggishness. As a dividend income fund, this fund is supposed to stick to high dividend-paying stocks, such as banks. It has done exactly that. But its mandate has proven to be poisonous over the past year, as one bank after another has run into problems. Other dividend fundshave done better because they’ve taken liberties with their mandate and bought hot stocks, particularly in the energy sector, that do not pay high dividends.

I expect PH&N to do much better in the future as the current turmoil in the financial sector eases. Yes, the recent mess will take time to clean up, but all signs are that the U.S. government is finally taking serious action to fix things. At press time, the financial sector looks undervalued to me. I believe that Canadian banks, in particular, are sound.

Because I like bank stocks, I’ll point out Mackenzie Maxxum Dividend Fund, which contains a high weighting of those stocks. This fund would not be my first choice since its management expense ratio is almost double that of PH&N Dividend Income, but if you already have other Mackenzie funds, you can switch to this one without incurring redemption fees. The fund also has a “corporate class” version that protects you from capital gains taxes if you invest outside your RRSP.

PH&N Canadian Equity Fund has fallenbehind its peers in recent months, but this unpretentious fund is cheap and it’s good. It does not make big bets. Its long-term track record is impeccable. And guess what? You can grab it for a management expense ratio of only 1.12%.

RBC O’Shaughnessy International Equity Fund follows a by-the-numbers approach to stock selection. It had a disappointing 2007 because of its low weighting in energy and materials stocks. The rising Canadian dollar also hurt, because most of the fund’s holdings are denominated in other currencies. The fund’s management expense ratio is somewhat pricey, but not outrageous compared to others in this category. You are paying for an investment formula that has been proven to work in the long term. This fund, like the others I’ve listed, should be in for better days ahead.

Betting on a rebound

These funds have recently lagged the market, but have the right ingredients to do better than their peers over the next few years.

Graham knew all about making money in hard times. He honed his investing techniques during the Depression, when he managed money on Wall Street and invented value investing. He later taught Warren Buffett how to invest. Before Graham died in 1976, he boiled his experience down to what he called The Simplest Way to Select Bargain Stocks.

If you’re a long-time reader of MoneySense, you already know about Graham’s Simple Way. Every year for the past four years, we’ve compiled a list of Simple Way stocks. Each year our list has outperformed the S&P 500. Assuming 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 be up 93% in 56 months, not including dividends. Over the same period, the S&P 500 advanced only 17%. We’re particularly pleased with the Graham picks over the past year. They gained 22% while the S&P 500 lost 8%.

In 1976 Graham calculated that a Simple Way investor would have achieved fairly consistent 15% average annual returns during the prior 50years. Our performance since 2004 has been close, with annualized returns of 15.4%.

Picking stocks using the Simple Way is like doing the two-step. In the first step, you seek stocks that are cheap and in the second you keep those that are relatively safe. Graham defined a cheap stock as one with an earnings yield that was 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 6.1% when we selected this year’s batch of Graham stocks, so we looked for stocks with earnings yields of 12.2% or more — which is equivalent to a priceearnings ratio of 8.2 or less.

We now come to the safety step. Graham detested excessive debt and insisted his picks be well capitalized to protect against bad times. He stuck to stocks with leverage ratios (the ratio of total assets to shareholders’ equity) of two or less.

Graham suggested selling his picks when you had achieved a 50% profit or no later than the end of the second calendar year after purchase. To make things even easier, we sell a crop of Graham stocks when we pick a new bunch.

With Graham’s criteria in hand, we used the MSN.com stock screener to find a short list of this year’s candidates. We narrowed it down by focusing on U.S.-listed stocks with market capitalizations of more than $2 billion. (All figures are in U.S. dollars.)

I have high hopes that Graham’s method will continue to do well, but all the usual warnings apply. Use Graham’s list as a starting point for your research not the final destination. If you don’t understand a company, pass it by. After all, there are lots of Graham-style bargains out there and you don’t have to buy every one.

The 2008 bargain bin

Ben Graham’s Simple Way identifies U.S.-listed stocks that are both cheap and safe. Nine stocks made our list.

2. THE LITTLE BOOK THAT BUILDS WEALTH
 by Pat Dorsey (Wiley, $21.99): Picking great stocks is like building a castle, says Dorsey. In both cases, you want to make sure you have a strong moat around you. When it comes to stocks, a moat is a built-in advantage that allows a company to defend its territory and churn out high profits, not just this year, but for decades.
OUR TAKE: A smart book about a neglected aspect of investing. If you want to know why Coca-Cola is a great buy for the long haul, but oil stocks aren’t, give it a read.

3. THE HAPPINESS PROJECT
(www.happiness-project.com, free): Gretchen Rubin was a lawyer before she decided to give happiness a try. Her personal project is to give every happiness tip and formula a test drive and report back to us on how well they work. Her site spans everything from 20 tips on reducing stress to 13 tips for dealing with a really bad day.
OUR TAKE: Oh, don’t be such a grouch. Give it a try! While some of Rubin’s tips are the type of thing you might expect from a cheesy motivational poster, more than a few strike us as genuine insights. If nothing else, we found it wonderfully reassuring to learn that someone else is just as stressed out as we are.

4. GETTING STARTED IN VALUE INVESTING
by Charles S. Mizrahi (Wiley, $23.99): There are tons of learn-to-invest books but this one stands out for its common sense as well as its deft balance of numbers and anecdotes. Mizrahi believes in buying good companies at a fair price and he shows you the simple techniques that can allow you to do the same.
OUR TAKE: One of the better introductions we’ve seen to value investing. Novice investors will learn a lot from this book; so will experienced investors who have enough bruises to appreciate the wisdom of what Mizrahi has to say.

5. MILLION DOLLAR JOURNEY
(www.milliondollarjourney.com, free): The young engineer who writes this blog hails from Newfoundland. His goal is to amass a million bucks by the time he hits 35. And, judging from the wide ranging material on his site, he’s willing to do just about anything to make that happen.
OUR TAKE: What makes this site work is the personality of the anonymous author. He describes himself as an “obsessive-compulsive personal finance guy,” but he’s actually immensely likable. While we could quibble with some of his views, there’s no doubting his spirit.

We hope that the greatest investor of all time has many, many good quotes left. But we also have to acknowledge reality. Buffett is 77 and even his steady diet of Cherry Coke and hamburgers can’t keep a guy going forever. Investors who would like to put their money into Berkshire Hathaway, Buffett’s flagship company, have to deal with the unpleasant fact that Buffett may be on his last lap or two as champion of the stock market marathon.

That raises a fascinating question: who is the next great Buffett-like investor going to be? He or she must be a great stock picker, of course. But that’s just the beginning. What distinguishes Buffett is not only his stock market acumen. It’s also his willingness to state his opinions in plain English, his independent turn of mind, and his willingness to treat investors as if they were his partners.

With that in mind, we went in search of younger investors with some of those same characteristics. We found four people in Canada and the U.S. who, in our admittedly subjective estimation, remind us of the master. One runs a hedge fund, one heads an investment trust, and the remaining two lead public companies. Each has demonstrated an ability to invest well. Each has been willing to go against the crowd and make courageous investing decisions. Each writes a Buffett-style letter to investors.

While we can’t guarantee that these investors will do anywhere near as well over the next decade as Buffett has done in the past, each of them has already displayed some moves that remind us of the great man. Whether you’re looking for a place to park your money or simply some smart investing commentary, we think they deserve your attention.

Prem Watsa
Fairfax Financial
Toronto

Who is he?: The 56-year-old CEO of Fairfax Financial Holdings has often been called the Buffett of the North. He’s run his insurance holding company since 1985 and has grown its share price by an average of 26% a year during that time.

Best call: Watsa and his investment team realized way back in 2003 that the U.S. housing boom was built on a shaky foundation of debt. They bet on a collapse in the mortgage market by buying what are called credit default swaps (CDS), a form of insurance against bad loans. Last year, Watsa’s CDS position soared in value as U.S. home loans soured. He turned a $341-million investment into a $2-billion-and-counting payoff.

Worst call: In 1998, Watsa acquired two U.S. insurers — TIG and Crum & Forster. Both were disasters and led to seven long years of dismal results for Fairfax.

Why he’s like Buffett: Watsa, too, is a value investor. And just as Buffett has built his empire around Berkshire, which is primarily an insurance company, Watsa has built his empire around Fairfax, which is also an insurance company.

Why he’s NOT like Buffett: Watsa is comfortable with far more debt and much higher risk levels than Buffett has been. Case in point: Watsa’s ill-advised U.S. acquisitions. From 2004 through 2006 some investors questioned whether Fairfax could survive.

What he’s doing now: Watsa believes we are in the early stages of a massive unwinding of debt. He is preparing his company for a once-in-a-century financial storm. He has 80% of Fairfax’s portfolio invested in ultra-safe treasury bills and government bonds. “Prolonged periods of prosperity lead to leveraged financial structures that cause instability,” writes Watsa. “We are witnessing the after effects of the longest economic recovery (more than 20 years) in the U.S. with the shortest recession (2001). Regression to the mean has begun — but only just begun!”

How to invest: Fairfax trades on the Toronto and New York exchanges under the ticker FFH. To learn more, read Watsa’s annual letters to shareholders at www.fairfax.ca. They’re informative, plain-spoken and always interesting.

Tim McElvaine
McElvaine Investment Trust

Vancouver

Who is he?: McElvaine, 44, is a native of Kingston, Ont., and a graduate of Queen’s University. He qualified as a chartered accountant and earned his Chartered Financial Analyst designation before going to work for Peter Cundill, the famed value investor and fund manager, in 1991. Five years later, McElvaine set up the McElvaine Investment Trust.

Best call: The McElvaine Investment Trust has produced 14% average annual returns for investors since 1997, more than doubling the results of a typical Canadian equity fund. It has never lost money over the course of a year.

Worst call: The Trust has produced decent returns over the past four years, but it has lagged behind the Canadian stock index during that period. Last year it managed to produce only a meagre 0.6% gain. McElvaine’s big sin? He’s decided to sit out the mad rush for commodity stocks. “I’m the only money manager I can think of to have entirely missed the oil and gas boom,” he says.

Why he’s like Buffett: McElvaine is funny, self-deprecating and likeable. He also makes a point of eating his own cooking — 98% of his personal portfolio is invested in his fund. Like Buffett, he regards buying a stock as buying a piece of the company. Consequently, he looks for stable, undervalued companies that can withstand economic storms and that aren’t tied to cyclical industries. He particularly likes companies that are headed by owners who have their personal fortunes tied up in their enterprises. At the end of 2007, his holdings included Glacier Ventures, a publisher of small-town newspapers in Western Canada; Maple Leaf Foods, the Toronto meat packager; and Citadel Broadcasting, a U.S. radio broadcaster.

Why he’s NOT like Buffett: McElvaine is a fund manager, not a CEO. That means he charges annual fees: 1% of your investment, plus 20% of any gains over 6%. Also, in contrast to Buffett’s sprawling empire, McElvaine runs a highly concentrated portfolio focused on a handful of what he considers outstanding values. At the end of 2007, a mere eight stocks made up 85% of his holdings.

What he’s doing now: Not much, according to McElvaine. “I make Homer Simpson look active,” he insists. But all jokes aside, he’s always on the lookout for undervalued stocks and special situations. The classic McElvaine holding is a firm of significant size in its own industry, with a reasonable debt load, headed by an owner-CEO who is in the middle of restructuring the company. “Take Michael McCain at Maple Leaf Foods,” says McElvaine. “He’s very focused on taking his company out of commodity products and into branded lines. If he can get it done the stock is worth significantly more than it is now.”

How to invest: The McElvaine Investment Trust is open only to qualified investors, which means that the minimum investment is anywhere from $10,000 to $150,000, depending upon your province of residence. For more info, visit www.mcelvaine.com — and, while you’re there, make a point of reading McElvaine’s annual letters. They’re both fun and illuminating.

Dr. Michael Burry
Scion Capital

Cupertino, Calif.

Who is he?: Burry, 36, studied economics at UCLA, but despite a long-standing fascination with the stock market, stuck to his original plan of becoming a doctor. In 1995, as he was finishing his training at Vanderbilt Medical School, his father died and Burry began investing a small amount of trust money. Two years later, he launched his own website and began to write about stocks in the only time he had free — between midnight and three in the morning. His dissections of value stocks attracted a following and in 2000, Forbes magazine named his hobby site as one of the top investing destinations on the web. By then Burry was in the third year of a residency in neurology at Stanford University Medical Center and he figured it was time to choose between medicine and money management. He set up a hedge fund, named it Scion Capital, and became a full-time investor.

Best call: Burry’s flagship fund has achieved a cumulative net return of about 455% after fees, or more than 20% a year, since 2000. Last year the fund soared 138% in value thanks to a huge bet that Burry had made on the subprime mortgage market. In similar fashion to Watsa, he had invested in credit default swaps and saw them nearly quadruple in value as the underlying loans started to default.

Worst call: After a string of big early victories, Burry hit a rough patch. In 2004 and 2005, the Scion Value Fund generated only single-digit returns. In 2006, it lost 18% of its value, largely as a result of Burry’s bet against the subprime mortgage market.

Why he’s like Buffett: Burry works largely by himself and offers only limited disclosure about what he’s up to. He describes himself as a “contrary-minded individual” who profits by working far away from the “groupthink capital of the world” — New York. He made a killing in 2002 by buying up the distressed debt of WorldCom, the failing telecom firm. He cashed in again a year later by moving into South Korean stocks, which after a decade of inactivity had finally started to chug ahead.

Why he’s NOT like Buffett: Burry’s willing to run bigger risks than Buffett — at least the current Buffett, that is. He’s more comparable to the young Buffett of the 1950s and 1960s, who ran a free-wheeling investment partnership before settling down to manage Berkshire Hathaway.

What he’s doing now: Waiting. Burry believes U.S. home prices still have lots of room to fall. His flagship funds are about half in cash, waiting for opportunities to emerge from the chaos he sees ahead. “I see the virtuous circle of the past few years turning into a vicious spiral,” he says. “All the good things that came with rising home prices are now going to occur in reverse.”

How to invest: That can be a challenge. Burry won’t discuss minimums or fees; would-be investors have to go to his website (www.scioncapital.com) and request info.

Ian Cumming
Leucadia National

New York

Who is he?: Cumming is a decade younger than Buffett, which puts him at a sprightly 67. He’s a Harvard MBA who has been chairman of Leucadia since 1978. Together with partner Joe Steinberg, who serves as Leucadia’s president, Cumming has built a long-term track record of investor returns that is actually slightly better than Buffett’s. He does it primarily by looking for broken down, unwanted companies that he can fix and sell for a profit.

Best call: One of his best deals came in 1991, when he bought Colonial Penn, a troubled insurance company, for $128 million. He sold it six years later for $1.3 billion.

Worst call: Cumming hasn’t made a lot of missteps, but his forays into developing medical products are a money-losing disappointment, at least for now.

Why he’s like Buffett: Cumming looks for deeply undervalued companies and is willing to invest in a myriad of industries. He owns a timber producer, a plastics maker, an iron ore miner, a casino, real estate, wineries — and the list goes on.

Why he’s NOT like Buffett: While Buffett rarely sells a company that he’s acquired, Cumming is happy to flip his investments. And while Buffett likes companies that make branded consumer products, Cumming has much of his money invested in low-cost producers of commodities. He’s particularly fond of buying companies with tax loss carryforwards and using those losses to help shelter Leucadia’s earnings. Unlike Buffett, Cumming has no public profile and never gives interviews.

What he’s doing now: He’s buying into AmeriCredit, a U.S. auto finance firm, and pouring money into an Australian iron ore project as well as into a company developing synthetic hemoglobin. But his outlook is definitely mixed. Consider this nugget from his 2006 report, in which he discusses the creative tension between his outlook and that of his partner Steinberg: “One of us thinks the sky is falling and the dollar on the edge of debasement. One of us thinks the efforts of half the global population who struggle toward a western standard of life and liberty will cause a global bull market that could last a long, long time.”

How to invest: Leucadia trades on the New York Stock Exchange under the ticker LUK. Before making any investment, go to www.leucadia.com and read Cumming’s annual letters to gain a sense of Leucadia’s far-flung operations.

In 2004 the top small stocks gained 54.8%. In 2005 the tiny superstars climbed 44.6%. In 2006 the pint-sized overachievers advanced a further 18.3%. If you had bought the top-rated top small stocks in 2004 and rolled your gains into the new bunch each subsequent year, you would now be up 170%, not including dividends. That compares to a gain of about 152% for the top-rated stocks in the Top 200.

I hope that my smaller stocks continue their hot streak, but I would urge you to be cautious. Small stocks are prone to big swings and tend to be riskier than larger stocks. You should limit them to a modest portion of your portfolio. Still, if you’re looking to add some spice to your portfolio, I think small stocks are definitely worth a look. They can grow far more rapidly than big firms if the conditions are right. And they frequently represent better value than their larger competitors.

The key is to do your homework before buying. I grade small stocks using exactly the same methodology as I do with large stocks. Each stock gets two letter grades—one for its growth prospects, the other for its value appeal. The grades run from A (for top-of-the-class superstars) to F (for struggling underachievers). I’m particularly interested in stocks that manage to earn an A or a B for both value and growth.

Some extraordinary qualities are needed to get high marks. On the value front, I look for stocks that pay dividends and that sell at low prices compared to their book values. They have to generate at least some earnings and they can’t carry much debt. On the growth side, I seek stocks that have achieved strong growth in sales and earnings over the past five years. Top-rated growth stocks also have to demonstrate healthy returns on equity, strong momentum, and reasonable price-to-sales ratios. (You can find a detailed explanation of the methodology, and a complete ranking of the best large stocks in Canada, in the December/January issue of MoneySense.)

From hundreds of small stocks, I’ve selected a few that score particularly well on both value and growth. You should, of course, do your own research before adding any of them to your portfolio. Here’s why they’re worth a look:

Akita Drilling (AKT.A, $11.22) is an oil and gas drilling and servicing contractor with operations in western Canada and Alaska. This year, it’s my highest rated small stock, earning an A for value and a B for growth. Akita’s only blemish is a little recent weakness in its share price. But that means that you can buy Akita at just above its book value and for only nine times its earnings. You get a 2.5% dividend yield in the bargain.

Clarke (CKI, $7.66) is a Halifax holding company controlled by George Armoyan, the famed value investor. He’s been very successful at buying into depressed firms, shaking them up and unlocking shareholder value. If you like Armoyan’s style, and want a convenient one-stop way to buy into a diversified portfolio of small stocks and trusts, Clarke is a tempting proposition.

H. Paulin & Co. (PAP.A, $8.50) keeps its eye on the nuts and bolts—literally. It describes itself as being the “first in fasteners” and is also active in fluid systems and auto parts. Based in Toronto, Paulin has faced some mighty challenges from the rising loonie and declining automakers. But it has still managed to grow its sales and profits, and trades at only 51% of book value.

Brampton Brick (BBL.A, $10.60) is Canada’s second largest producer of clay bricks; it also makes paving stones and other landscape products. The Brampton, Ont., firm sells to both Canadian and U.S. customers and has been hard hit by the recent collapse in the U.S. housing market. Still, it could be a bargain: it trades below book value and pays a nice 1.9% dividend.

Amerigo Resources (ARG, $2.34) is headquartered in Vancouver, but makes its money by extracting copper and molybdenum from the tailings of the world’s largest underground copper mine in Chile. I like the company’s low debt levels, generous 16.6% earnings yield, and 5.6% dividend yield. Given the unpredictability of metal prices, Amerigo is likely to be a wild ride, but if you’re willing to take a flyer, it’s an interesting speculation.

MoneySense readers have been among those who have profited handsomely from Graham’s Simple Way. Since I started picking Simple Way stocks for MoneySense in 2004, the method has handily outperformed the S&P 500 each and every year. Assuming you purchased equal dollar amounts of each Simple Way stock, stashed them in your RRSP, and rolled the profits into new Simple Way stocks each year, you would now be sitting on a gain of 59% in 44 months, not including dividends. Over the same period, the S&P 500 advanced only 27%, less than half as much as the Graham picks.

Skeptics will put the recent success of the Simple Way stocks down to luck. I beg to differ. The 14% annualized return provided by the Simple Way since 2004 is close to what the master himself would have predicted. Back in 1976 Graham calculated that if you had followed the Simple Way, you would have achieved fairly consistent 15% annual returns during the prior 50 years. Thirty years later, his system is still churning out results in line with historical returns.

Picking stocks using the Simple Way is like doing the two-step. In the first step, you seek stocks that are cheap and in the second you keep those that are relatively safe. Graham defined a cheap stock as one with an earnings yield that was 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 6.1% when I selected this year’s new batch of Graham stocks, so I looked for stocks with earnings yields of 12.2% or more. (If you’re confused by all this talk of earnings yields, no need to fret. The earnings yield on a stock is simply the earnings per share divided by the share price. It’s the inverse of the more popular price-to-earnings ratio. An easy way to convert an earnings yield to a P/E ratio is to divide 100 by the earnings yield. So, looking for stocks with an earnings yield of 12.2% or more is roughly equivalent to searching for stocks that possess a P/E ratio of 8.2 or less.)

We now come to the safety step of the Simple Way. Graham insisted on investing with a margin of safety because he had suffered through the crash of 1929 and witnessed the carnage that resulted from companies carrying too much debt. He insisted that his chosen companies be well-capitalized to protect themselves against bad times. For safety’s sake, Graham stuck to stocks with leverage ratios (the ratio of total assets to shareholders’ equity) of two or less.

Finally, we come to the question of when to sell Simple Way stocks. Graham suggested waiting for either a 50% profit or for no later than the end of the second calendar year after purchase. I take the more straightforward approach of selling the previous crop of Graham stocks whenever I pick a new bunch.

With Graham’s criteria in hand, I used the MSN.com deluxe stock screener to find a short list of this year’s interesting candidates. I narrowed it down by focusing on those U.S. stocks with market capitalizations of more than $1.5 billion. (All figures are in U.S. dollars.)

The 2007 Bargain Bin is crammed with old economy stocks, many of them from the oil and gas sector. Patterson-UTI Energy (PTEN) of Texas, Helmerich & Payne (HP) of Oklahoma, and Unit (UNT) of Oklahoma all drill for oil and natural gas, primarily in the southwest U.S. Hercules Offshore (HERO) of Texas is yet another driller, although it conducts most of its business in the shallow waters of the Gulf of Mexico.

If you’re in a gambling mood, keep an eye on IPC Holdings (IPCR), which provides hurricane reinsurance. IPC’s fortunes rise or fall depending on the severity of each year’s hurricane season. If this year proves to be as bad as 2005, when Hurricane Katrina slammed New Orleans, IPC will suffer. On the other hand, the company could gush profits if the season is mild. The bottom line is that buying IPC is like playing a game of hurricane chicken and is not for skittish investors.

Those of you who like computers should take a look at Western Digital (WDC), the only tech company to make this year’s list. It makes hard drives for computers and is faring well despite aggressive competition, but the market isn’t giving it a lot of credit for its success.

I have high hopes that Graham’s method 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. If you don’t understand a company, or feel qualms about it, you should follow the maxim of Warren Buffett, the best known of Graham’s students, and put the decision in the “too hard” pile. After all, there are lots of Graham style bargains out there and you don’t have to swing at each and every pitch.

In fact, retirement for many of us is going to be an exercise in calculating odds and balancing one probability against another. Should we treat ourselves to that grand tour of Europe? Or deny ourselves because we may need the money years from now to pay for a nursing home? Should we invest aggressively to increase our chances of growing our nest egg? Or play it safe and take as few chances as possible?

These are anxiety-inducing questions and, ironically, you can blame that anxiety on the long, healthy lives we’re now living. Back in the 1920s, a newborn Canadian could expect to live for less than 65 years. Today, a baby born in Canada can expect to live to 80. So while our grandparents and great-grandparents didn’t spend a lot of time thinking about retirement—and with good reason!—we now have to budget and plan for 20 years or more of not working.

A lot can go wrong over a couple of decades. And even if you set things up perfectly for a nice 20-year retirement, fate has an odd sense of humor. After years of planning, you may die young—or live long, long past what you thought would be your expiry date.

One of the most common mistakes that people make in retirement planning is basing everything on the notion that they will live to what they believe to be the average life expectancy. You should remember that the average life expectancy is just the midpoint in a huge range of possibilities.

Among other things, bear in mind that the life expectancy figure you read in the newspaper is usually expressed in terms of what a newborn child can expect. The figure assumes there will be a steady number of deaths at every age along the way—a few people will die in childhood, a few others in adolescence, and so on. Those early deaths drag down the overall figure. So if you’ve dodged disease and accidents and made it all the way to 65, your life expectancy is considerably greater than the average for a newborn would suggest. Someone who is 65 today has a better than even chance of living to 85.

Remember, too, that the average life expectancy figures are just that: averages. Some people enjoy far fewer years; some enjoy many more. The average life expectancy for seniors may be 85, but that doesn’t mean you can ignore anything past 85. About half of seniors will live beyond that point— sometimes well beyond. The 30-year retirement is not uncommon and you have to be prepared for the possibility that you’ll be blowing out the candles on your 100th birthday.

The problem, from a financial perspective, is that there are no guarantees. Moshe Milevsky, associate professor of finance at York University in Toronto, points out that a 65-year-old man who retires today faces an 8% chance of dying before he turns 70. He also faces a nearly identical 8% chance of living past 95.

Think about the practical implications of those figures. Our 65-year-old man may expect to die relatively young. He may burn through his cash and treat himself to lots of expensive indulgences—only to find that, gosh, he’s a Methuselah who has to live the last quarter century of his life trying to make ends meet on a meager budget.

On the other hand, he could play it safe and pinch pennies to ensure he will have enough to last until he’s a centenarian. But, if so, he faces a real possibility of finding himself in a hospital bed at 68 or 69, listening to a doctor deliver a grim diagnosis, and cursing himself for not enjoying life more when he had the chance. The odds of disappointment are identical no matter which option our hypothetical 65-year-old chooses, so how does he—or you—make a choice? The following plan can help you make the most of the retirement odds.

Calculate your must-haves

You often hear retirement planning boiled down a single figure: “you need $1 million to retire well.” A smarter approach is to think of your retirement plans as consisting of two separate figures: one for things you must have, the other for things it would be nice to have.

The first and most important part of retirement planning is taking care of things you must have. You want to ensure you have enough to live on without feeling deprived of anything vital.

You can estimate your target figure by toting up how much you spend in all areas, then deducting the expenses that will disappear in retirement, i.e. no more mortgage payments (because the house will be paid off), no more child care or tuition payments (because the kids will be adults), no more retirement savings (because you will be retired). You should also deduct any luxuries you could live without in retirement, such as a second car. You can also subtract the cost of commuting to the office, work clothes, and so on.

The amount that’s left represents what it would cost you to maintain the essentials of your current lifestyle in retirement, and that figure is probably a lot lower than you think. Most middle-class couples arrive at a must-have figure of $30,000 to $40,000 in after-tax income.

Calculate your nice-to-haves

We all have dreams and you should budget for those, too. Maybe you want to take that African safari, golf every day, or winter down south. You should size up what it would take to pay for whatever bliss you desire and regard that figure as the second part of your retirement planning.

Just one tip: when assessing your nice-to-have list, remember that age takes its toll. Right now you may dream of traveling the globe. Once you’re past your early seventies, however, you’re likely to discover that your wanderlust is diminished. Similarly, you may find that golfing every day is no longer a pleasure once you’ve hit 75. So by all means budget for luxuries, but keep things within reason. You’re not likely to be globe-trotting for 30 years nor whacking iron shots to the green on your 95th birthday.

Count on government

Despite what the fear mongers would have you believe, Canada Pension Plan (which is funded by contributions from you and me) is in fine shape. Old Age Security (which is funded out of general government revenues) looks to be on solid ground, as well.

If you’ve worked in Canada all your life, you can expect to receive $11,000 to $16,000 a year from those two sources, depending upon what you made during your working years and how early you start collecting your pension cheques. A husband and wife who have both worked until retirement at 65 can expect $22,000 a year or more between the two of them. That money will keep pouring in as long as you live, with no particular planning required on your part.

You should compare what government will provide you with what you figure your minimum retirement needs will be. If you and your spouse figure you can maintain the must-have parts of your current life on, say, $33,000 a year, the good news is that retirement becomes a very affordable proposition. You may have to add only $11,000 a year in after-tax income from corporate pensions or savings to ensure the key components of your retirement plan.

Factor in pensions and RRSPs This brings us to the thorny issue of pensions. You may be fortunate enough, if you’re a public servant or work in the right industry, to be the recipient of a pension that guarantees you a “defined benefit” in retirement. If so, you can simply contact your employer’s human resources department to find out the size of the monthly retirement cheque you can expect.

If that amount is enough to bridge the gap between government stipends and your retirement needs, then congratulations! Your retirement planning is largely done. You may still want to contribute to an RRSP to finance luxuries, to provide you with a buffer against inflation, and to guard against the possibility that your employer will go bust and renege on its pension promises, but, in all probability, those RRSP contributions will simply increase your security, not determine your retirement lifestyle.

Most of us, though, aren’t in that position. Maybe you don’t have a pension plan. Or perhaps your employer’s pension plan is a “defined contribution plan” that only promises how much your employer will contribute each year you work, but leaves the actual investing up to you. Or maybe your employer’s defined benefit payouts aren’t enough to bridge the gap between government pensions and what you need. In any of those cases, you’re going to have to deal with uncertainty.

So get a handle on risk

This is where playing the odds becomes vital. Some retirees insist on playing it safe and keeping all their money in bonds and GICs. Others go for the gusto by betting on high-yield real estate investment trusts, penny stocks and small growth firms in hopes these high-risk, high-reward bets will provide them with the income they want.

Both approaches are flawed. Stashing everything in bonds and GICs raises the risk that inflation will whittle away the real value of your savings. On the other hand, betting on high-risk stocks or trusts raises the odds that you’ll make a big mistake and wipe out a chunk of your savings.

The best solution for nearly everyone is a well-diversified portfolio that has 30% to 50% of its assets in various fixed-income investments, such as bonds and GICs, and the remainder in a wide variety of stocks from Canada and other countries. One good approach to building such a portfolio is outlined in our article about couch potato investing.

No portfolio, though, can guarantee a given return. What makes retirement planning so difficult is that you’re drawing down your portfolio for living expenses at the same time as the markets are bobbing up and down. The first few years of your retirement are particularly crucial. If you have the bad luck to retire at just the moment that the markets head into a bear market plunge, your withdrawals combined with stock market losses could put a hole in your portfolio from which it will never recover. On the other hand, if you retire at the same moment the markets decide to go on a tear, the surging market returns may more than cover your early withdrawals. You may actually increase your net worth in retirement.

If you want to make your money last for 30 years, count on withdrawing no more than 4% of its initial value each year, adjusted for inflation. You should begin your retirement by withdrawing $4,000 a year for each $100,000 you start with. If inflation is running at 2% a year, you would withdraw $4,080 the next year, $4,162 the following year, and so on.

The 4% figure comes as a shock to many people, who assume that they can count on their portfolio for 10% or more in the way of annual payouts. To read more about the reasoning behind the smaller figure, refer to The 4% Solution below.

Balance the present and the future

Here’s where individual preferences become important. While a 4% withdrawal rate gives a well-balanced portfolio an excellent chance of surviving 30 years, it’s very much a pessimist’s strategy. Chances are that things will turn out better than the worst case. If they do, you stand a good chance of leaving behind a tidy fortune. Your heirs will no doubt like this arrangement and if you want to leave them a big bequest, that’s fine—but it’s probably not the optimal deal for you. In fact, if you apply the 4% withdrawal figure to your entire portfolio, you’re probably erring on the side of caution and living on less than you could in retirement.

A better idea is to treat the must-have and nice-to-have portions of your portfolio in different ways. When it comes to your must-have portion, play it safe and count on a 4% annual withdrawal rate. If you calculate, for instance, that you’re going to need to generate $16,000 a year on top of CPP and OAS to provide you with the necessities of your life, you should accumulate at least $400,000 in RRSP savings or the equivalent in corporate pension plans. That $400,000 should be able to fund an inflation-adjusted withdrawal rate of $16,000 for as long as you live.

If you don’t want to worry about the ups and downs of a portfolio, you can use some of your must-have savings to purchase an annuity that will provide you with a guaranteed payout for the rest of your life. Be sure to compare annuities from different companies to get the best possible deal. Look at all the different options available. Some annuities pay your heirs a lump sum if you die early; some are inflation-protected; some cover both you and your spouse. Seek the advice of a good fee-only financial planner before buying. Put particular emphasis on making sure that the insurance company that offers the annuity is as financially sound as possible. (Look for at least an AA rating from a rating firm such as A.M. Best. To learn more about these ratings, go to Ambest.com.) You may even want to split the annuity portion of your musthave money between two or more companies to ensure no single disaster can swallow up your savings.

Once you’ve built a fortress around the must-have component of your portfolio, you can treat the nice-to-have portion with more freedom. You can and should plan to run through a chunk of your nice-to-have budget in the early years of retirement, when you’re going to be most active. By the time you turn 75, your appetite for travel and other luxuries is likely to diminish and by the time you hit 85, many of your discretionary expenses will have dropped away completely. If your nice-to-have money is running low at that point, so be it. You will have extracted maximum value from your nice-to-have money when you were still healthy enough to enjoy it, while protecting your future by ensuring that your must-have needs are well covered. That’s the retirement we all want and it’s well within your reach.

The 4% Solution: More on making your money last

William Bengen, a financial planner in California, is the author of a long, but easy-to-understand explanation of how different withdrawal rates can affect your retirement. Originally published in the Journal of Financial Planning, “Determining withdrawal rates using historical data” is a classic in its field. His key finding? A 4% withdrawal rate is the most a truly long-term investor should consider. If you’re looking for a shorter take on the same subject, go to Scottburns.com and check out the “The Spender’s Portfolio and Portfolio Survival” section. The examples used are from the U.S., but the same math applies to Canada.