Value stocks: When cheap isn't good enough

It is a well-known fact that low price-to-earnings (P/E) stocks – value stocks, in other words – earn higher returns on average than high P/E stocks, or growth stocks. At the same time, it is a commonly held misconception that all value investors do is sort stocks by P/E and invest in those with low P/E.

But considering low P/E stocks is only part of the value-investing process. This is because, on average, about 39 per cent of all low P/E stocks produce negative returns for the 12 months following their selection.

How do value investors separate the good low P/E stocks from the bad ones? They do so by painstakingly valuing each low P/E stock to determine its intrinsic value; they then only invest in the stocks that afford them a satisfactory margin of safety. These are the good low P/E stocks.

The challenge is that it can be difficult for the average investor to perform this process. My research, though, suggests that there is an additional screening that can enable an investor to identify the low P/E stocks worth investing in without having to go through the time-consuming task of estimating each stock's intrinsic value.

I examined Canadian companies that are listed only on Canadian exchanges for the period May 1, 1985 to April 30, 2009. I only examined Canadian stocks without interlistings on other exchanges to make sure the results were driven by Canadian investors. In addition, interlisted stocks are larger, followed by many analysts and better known than non-interlisted stocks and I did not want the results to be driven by the well-known size effect, in which small stocks typically perform better than large ones. My sample included 7,145 annual observations belonging to 1,237 unique companies.

First, I divided the stocks in my sample into value and growth categories by sorting them into four equal groups, or quartiles, on the basis of their trailing P/E ratios. Value stocks were defined as those that fall in the lowest quartile.

I then sorted all these value stocks, according to the data available at the time, by historical market capitalizations, stock liquidity (i.e., trading volume divided by number of shares), asset turnover (i.e., revenues divided by assets) and year-over-year growth in earnings before interest and taxes (EBIT) and earnings per share (EPS). In each case, I assigned values to each of the above financial metrics within each firm based on the sorted rankings.

The sum of the above values for each firm formed the basis for a firm's composite indicator, or FCI. I then ranked all value stocks by the FCI indicator and formed six value portfolios with FCIs from low (0) to high (5). The indicator was constructed to imply that the lower the FCI the better a stock is. I repeated the process for every year in my sample period.

I found that value firms with the lowest FCI indicator had a mean annual return of 36.89 per cent. The highest FCI-value firms had a mean annual return of minus 11.35 per cent. By comparison, the mean annual return for all value stocks in my sample was 16.86 per cent.

These are large differences. Screening the low P/E stocks by the FCI indicator adds considerable value to an investment strategy. For example, a strategy that involves shorting the high FCI value stocks and buying the low FCI value stocks would have beaten the low P/E portfolio by more than 30 per cent over the May 1, 1985 to April 30, 2009 period.

This is history, of course. How about the future? Which non-interlisted value stocks currently receive a low FCI and which ones a high FCI? The accompanying table shows stocks with a FCI of 0 or 1, as well as those with an FCI of 4, as there were no stocks that scored 5 this time around. While there is no guarantee that in any one year value will beat growth, this approach can at least identify the value stocks that will do better than average.