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Due to the market's meteoric rise, most stocks are no longer cheap. But these four bargain stalwarts are worth a look.
As a value investor, I can often be accused of being a contrarian. Last February, as the markets settled into their darkest depths, I was enthusiastically pointing to the big bargains on offer in my article “The case for optimism.” But this February, as investors cheer on the markets’ remarkable recovery, I’m much less upbeat. That’s because when you consult the right numbers it’s clear that most of last year’s bargains are no longer available.
That’s not to say that the markets couldn’t continue to advance smartly, because as legendary value investor Benjamin Graham observed, the market is a voting machine in the short term. Stocks can stay on the high side of fair value for extended periods, and indeed, they have been more expensive on many occasions over the last decade. But Graham also pointed out that over the long run, the market acts more like a weighing machine, and eventually prices tend to settle down to levels that make sense.
That’s why I like to measure the market using Graham & Dodd’s price-to-earnings ratio, named in honour of the co-authors of the value investing bible Security Analysis. The Graham & Dodd P/E ratio is calculated by dividing the market’s current price by its average earnings over the past 10 years. As a result, the ratio focuses on long-term earnings trends without being overly influenced by temporary fluctuations in the business cycle.
Stocks tend to trade at bargain levels when the Graham & Dodd P/E ratio falls below 10. History shows that long-term returns from such low ratios have been excellent. However, stocks have been less kind to long-term investors when the markets hit ratios of 20 or more
So, where are we today? The Graham & Dodd P/E ratios in both Canada and the U.S. recently moved back above 20. As a result, both markets are expensive compared to their long-term historical norms.
But it’s also true that stocks have been expensive for much of the past decade. The Graham & Dodd P/E reached a dizzying high of 44.2 at the peak of the internet bubble. It then declined to a median level of 26.1 during the last decade. The market only moved below 20 during the recent collapse when it briefly slipped under its long-term median of 15.7. So recent history shows us that stocks can climb above 20 and stay there for a while. Still, caution is warranted because, as we’ve seen, returns during the first part of this century were less than generous.
Despite the recent rise in prices, a diligent search still reveals a few bargains. After all, individual stocks follow their own patterns and a few will be cheap even when the markets are pricey.
When looking for investments in a hot market I like to stick to safer names. That’s why I’ll focus on the 60 large stocks in the S&P/TSX 60 index. The index contains premier Canadian firms which tend to be safer than their smaller counterparts.
I also appreciate a strong record of dividend growth over the last five years, which I view as a measure of a firm’s success. Even more importantly, stocks that managed to maintain or grow their dividends during the economic turmoil of the last few years have demonstrated their mettle in hard times.
Only a handful of stocks in the S&P/TSX 60 sport good five-year dividend growth records. Even fewer pay dividends that are well supported by earnings. I’ll highlight four that pass both tests, and also happen to trade at modest price-to-earnings ratios.
I’ll start with Telus (T.A, $32.36). The Vancouver-based telecom giant is a favourite of dividend investors due to its juicy 5.9% dividend yield and 18.9% average annual dividend growth rate over the last five years. Telus’s dividend payout ratio (dividends divided by earnings) is a reasonable 53%, which indicates that its dividend is well covered by earnings. The firm also trades at a low price-to-earnings ratio of 9.1. But the low price comes with some risk due to the arrival of new competition in the form of recent wireless startup Globalive.
Second up, Enbridge (ENB, $47.93) pays a dividend yield of 3.6%. The pipeline company has a very pleasing habit of regularly growing its dividend, which it has done at an average annual rate of 13.2% over the last five years. Even better, it announced a 15% dividend boost in December and Enbridge has been paying dividends to its shareholders for over 50 years.
The third member of my dividend growth quartet is Metro (MRU.A, $39.10) which generates a modest 1.4% dividend yield. But the grocery store chain from Montreal is a regular dividend booster (10.1% annually over the last five years) and has a strong growth record. For instance, the company’s revenues have climbed at an average annual rate of 13% over the last five years and analysts expect even more good things to come.
Finally, my current favourite is Canadian Tire (CTC.A, $56.38), which pays a 1.5% dividend yield, sports a price-to-earnings ratio of 13.5, and a five-year annual dividend growth rate of 10.9%. Importantly, the firm’s earnings have held up quite well during the economic collapse. It has earned a profit every quarter over the last two years and every year for the last decade. That sort of resilience puts the Toronto-based company in good standing with investors.
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