Boost returns with low P/E stocks

Canadian value investors pay attention to what money manager Francis Chou has to say in his letters to investors. True to form, his recently published semi-annual letter is well worth reading.

Amongst other topics, Mr. Chou discusses the beleaguered pharmaceutical giant Valeant (VRX). As a fan of market history, I was intrigued by a comment on price-to-earnings ratios (P/E). He noted that, “we will analyze the situation using a multiple of 14, which is the average P/E multiple a company on the Dow Jones Industrial Average has sold for over the past last 100 years”

That got me wondering how an investor would have fared by sticking to stocks with positive P/E ratios below 14. My colleague and MoneySense senior editor Mark Brown, kindly ran a series of backtests on Bloomberg to help me get to the bottom of the issue.

Mr. Brown started by looking at a portfolio of Canadian stocks with market capitalizations in excess of $500 million, with their primary listings on the TSX, over the 20 years through to the end of 2015. The portfolio was weighted by market capitalization (just like most indexes, index funds, and exchange traded funds) and rebalanced annually. The performance of this baseline portfolio can be seen below.

The baseline portfolio had an average compound annual return of 9.75% over the 20 years while the S&P/TSX Composite index gained 7.59% annually over the same period. The lower return for the index is attributable to the different universe of stocks used for the backtest.

As an aside, compound annual returns, which represent the gains achieved by buy-and-hold investors, are lower than mean (or average) annual returns for volatile portfolios. For instance, a portfolio that climbs 20.0% one year and 4.0% the following year has a mean annual return of (20.0%+4.0%)/2 or 12.0%. Its compound annual return is (1.20*1.04)^(1/2)-1 or 11.7%. I make a point of presenting compound annual returns, unless stated otherwise, because they are both lower and more reflective of investor returns.

With the baseline in hand, we can now consider the impact of buying stocks with positive P/E ratios of less than 14 while maintaining all of the other requirements of the baseline portfolio. The results are shown below.

You can see that adding the low-P/E requirement boosted returns in a big way. The low-P/E portfolio generated compound average annual returns of 13.79%, which is just over four percentage points more than the annual compound return of the baseline portfolio.

Buying stocks with lots of earnings at a low price is a simple concept. But, as Charlie Munger observed, one should take a simple idea seriously. After all, it can be quite profitable.

Safer Canadian Dogs

Investors following the Dogs of the Dow strategy want to buy the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), hold them for a year, and then move into the new list of top yielders.

The Dogs of the TSX works the same way but swaps the DJIA for the S&P/TSX 60, which contains 60 of the largest stocks in Canada.

My safer variant of the Dogs of the TSX tracks the 10 stocks in the index with the highest dividend yields provided they also pass a series of safety tests, such as having positive earnings. The idea is to weed out companies that might cut their dividends in the near term. Just be warned, it’s a task that’s easier said than done.

Here’s the updated Safer Dogs of the TSX, representing the top yielders as of September 6. The list is a good starting point for those who want to put some money to work this week. Just keep in mind, the idea is to hold the stocks for at least a year after purchase – barring some calamity.

Source: Bloomberg, September 6, 2016

Notes

Price: Closing price per share

P/B: Price to Book Value Ratio

P/E: Price to Earnings Ratio

Earnings Yield: Earnings divided by Price, expressed as a percentage

Dividend Yield: Expected-Annual-Dividend divided by Price, expressed as a percentage

As always, do your due diligence before buying any stock, including those featured here. Make sure its situation hasn’t changed in some important way, read the latest press releases and regulatory filings and take special care with stocks that trade infrequently. Remember, stocks can be risky. So, be careful out there. (Norm may own shares of some, or all, of the stocks mentioned here.)