A valuable strategy for Canada

The basic notion of buying low and selling high is one that has had success for decades. Warren Buffett, perhaps the most prominent successful investor of our times, uses value as one of his main investment philosophies. However, recently there have been publications questioning if value investing can continue to succeed, particularly with U.S. stocks.

The value strategy

Although there is some correlation between the Canadian and U.S. stock markets, there are also many differences. A specific strategy may not work in one market but may succeed in the other.

To test the success of value investing, I ran a value-based strategy using Morningstar CPMS separately on U.S. stocks and then on Canadian stocks. The strategy invested in stocks with the lowest combined values of price-to-sales, price-to-earnings and price-to-cash flow. I added a restriction of stocks having at least a market cap of $500 million in Canada and $2 billion in the U.S. to exclude the smaller cap stocks (U.S. stocks have a much larger average market cap). A maximum of five stocks per sector were held in the portfolio.

The factors used in the strategy are:

• Price to trailing sales
• Price to trailing earnings
• Price to trailing cash flow
• Market cap of at least $500 million on Canadian stocks
• Market cap of at least $2 billion on U.S. stocks

The results

I back-tested the strategy from December 2006 to September 2017, using an initial investment of $10,000. During this process, a maximum of 10 stocks were purchased and equally weighted. Semi-annually (at the end of December and end of June), the portfolio would be replaced with the best 10 stocks based on the strategy’s criteria.

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The U.S. strategy produced an annualized total return of 3.9% over the period while the S&P 500 total return index advanced 7.8%, lagging the index by 3.9%.

On the other hand, the Canadian strategy produced an annualized total return of 19.3% over the period while the S&P/TSX composite total return index advanced 4.5%, resulting in an outperformance of 14.5%. The investment of $10,000 grew to over $66,710 in just over 10 years. You can find a list of the 10 stocks that are currently in this strategy below.

From these results it seems that value investing can still succeed in the current Canadian stock market even if the same approach produces unfavorable results on stocks south of the border. Interestingly, the strategy produced significant outperformance in Canada in recent years. September 2017 YTD performance for the strategy was 32.4% vs. 4.4% for the TSX. The strategy also beat the index each of the last 5 years, with an average outperformance of 15.4%.

Canadian value strategy performance

A word of warning

Although these returns are impressive, quantitative stock strategies come with stipulations. This strategy is based entirely on the criteria mentioned above. No consideration is placed on any of the stocks’ operations, industry outlook or management. You may or may not want to take those items into account. The back-test also assumes closing day prices and only at the last business day of the second and fourth quarters of each year. In reality, you will likely trade at a different price.

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Value investing in particular may be difficult to actually follow for some people. It will involve buying some stocks where prices have been falling. This can prove quite challenging for anyone hesitant to buy stocks on a downward trend, and many investors are.

As always, do your due diligence and understand the risks and implications of a specific investing strategy before applying it.

Buy cheap (in Canada)

Although there are arguments that the returns of value investing may be diminishing, this does not mean all value investing approaches will fail to outperform in the future. In particular, value investing applied to Canadian stocks can result in significant gains, especially considering recent history.

If you are looking for a simple quantitative investing approach in Canada, buying cheap may be right for you.

* Morningstar CPMS includes all stocks in the TSX Composite Index and the BMO Small Cap index. It also includes other stocks based on request with at least 3 analysts of coverage and 5 quarters of earnings. Currently the universe has 699 stocks in Canada.

About Michael Pe, CFA

As a CFA charterholder with over a decade of experience in the financial industry, Michael writes about the real estate market, personal finance and investing.

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