Explore the good, the bad and the ugly of value investing before adopting it. It’s easy to learn about its good side, but the bad and the ugly aren’t always advertised.
A simple method highlights a few of value investing’s strong and weak points. The method sorts the 60 large Canadian stocks in the S&P/TSX 60 Index by their price-to-earnings ratios (P/E) at the end of each year.
It puts an equal dollar amount of the 10 stocks with the lowest positive ratios in its portfolio, holds them for a year and then repeats the process.
The low-P/E approach generated an astonishing average annual return of 16.7 per cent over the 16 years from the end of 2002 to the end of 2018, according to Bloomberg’s back-testing facility. By way of comparison, the S&P/TSX 60 itself climbed at an 8.2-per-cent annual rate over the same period. The low-P/E portfolio outperformed the index by an average of 8.5 percentage points annually. (The returns herein include dividend reinvestment. They do not include fees, commissions, taxes or other trading frictions.)
I expect the low-P/E method to continue to do well over the long term.
But I doubt it’ll outperform the market by such a wide margin and it may underperform for very long periods. For instance, it trailed the market over the past four years with total gains of 11.7 per cent while the index climbed 13.6 per cent. Periods of poor performance are one of the bad parts of value investing and stock-picking more generally.
The low-P/E portfolio also suffered from bad downturns in the past. It fell 43 per cent in 2008 and lagged the market, which declined 31 per cent that year. The peak-to-trough declines for both would be more dramatic when measured using monthly or daily data.
Similarly, the market outperformed the low-P/E portfolio in five of the past 16 annual periods. Last year was one such occasion because the low-P/E portfolio fell 11 per cent while the index declined 7.6 per cent.
Value investing – and stock picking – can get really ugly when it comes to individual stock returns. The accompanying table provides a return scorecard for the low-P/E method. It shows the returns – sorted from high to low – generated by the 10 low-P/E stocks each year, starting with 2008. Note that the actual stocks in question change from year to year as P/Es change.
The stocks generated a wide range of returns each year with big successes and ugly duds. About 30 per cent of the value picks lost money the year after being selected and about 43 per cent of them trailed the market.
While the low-P/E portfolio suffered a loss of 43 per cent in the crash of 2008, some of the individual stock returns were downright ugly. Three of the 10 low-P/E stocks fell by more than 75 per cent in 2008. It’s the sort of thing that scares the stuffing out of investors. Keep in mind, the method assumes that investors had the nerve to reinvest their dividends on the way down.
Even worse, the portfolio was rebalanced at the end of 2008. As it happens, the three stocks that fell by more than 75 per cent in 2008 remained in the portfolio as low-P/E darlings for 2009. To rebalance the portfolio, an investor had to sell shares that fared relatively well in 2008 while loading up on the three stocks that lost more than three-quarters of their value along with other poor performers. Doing so would have taken nerves of steel because the three were resource stocks that some feared were on the brink of bankruptcy.
As it happens, the three firms did not go bankrupt and bounced back in 2009 with astounding returns of 227 per cent, 261 per cent and 512 per cent. But who knows what would have happened if the crisis had lasted a little longer?
The simple low-P/E method generated good long-term returns. But I doubt many investors would have been able to stick with it through its bad and ugly periods. Practically speaking, most investors should opt for less-stressful low-fee balanced funds instead.
But if you’re undeterred and want to follow the method, welcome aboard. The 10 stocks that currently pass the low-P/E test can be found in the accompanying table. Be sure to buckle up because you’re in for a hell of a ride.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.