Stingy Investor Contact - Subscribe - Login
  Home | Articles | Screens | Links | SNW | Rothery Report
 
The Value Ratio Approach

In the May 1999 edition of the Canadian MoneySaver, I reviewed several stock-picking strategies that revealed the positive effect that one fundamental factor can have on investment returns. This article reviews some of my research into a slightly more complicated two factor approach which I refer to as the Value Ratio (VR) approach. While stocks selected solely on the basis of high dividend yield (yield) or low price-to-earnings ratio (P/E) have performed well in the past, a combined approach with the VR method may achieve better performance. For comparative purposes the yield-based Beating the TSE method is also presented and some of the potential pitfalls associated with using the VR approach are discussed.

The current investigation is limited to the 35 stocks that are in the TSE 35 index (Table 1). This index is composed of large, sound and well known Canadian companies. The approach could be easily applied to other indices but the TSE 60 is less than a year old and the TSE 300 contains a few issues of questionable soundness.

The value ratio approach is based on selecting stocks that have low ratios of P/E-to-yield (thus the term Value Ratio). In algebraic terms the value ratio of a stock is given by:

Value Ratio = (P/E) / (Dividend Yield) = (Price/Share * Price/Share)/(Earnings/Share * Dividends/Share)

As the formula demonstrates, stocks with low value ratios have a combination of low prices, high earnings, and high dividend yields. Intuitively, these characteristics should be viewed as quite favorable to the buyer of securities. The VR approach is initiated by sorting the stocks in the TSE 35 by VR each year (with the prior removal of any stocks that have no dividends or no earnings). A VR portfolio is created by purchasing equal dollar amounts of a number of stocks with the lowest VRs. The portfolio is held for a year, sold and a new one is made based on a fresh VR sorting. The historical results of applying this technique to portfolios with one, five and ten stocks are presented in Table 2. All three portfolios beat the TSE 35 total return, although the ten-stock portfolio did not fare nearly as well as the others. It should be noted that, in the one-stock case, I am using the term portfolio rather loosely since one stock can hardly be said to constitute a portfolio.

Comparative results for the Beating the TSE approach are included in Table 2 courtesy of a study undertaken by Jennifer Hadrevi (See www.ndir.com/SI/strategy/dogs.shtml). Her results may be slightly different from those calculated by David Stanley in his Canadian MoneySaver articles since the portfolios shown in Table 2 are rebalanced on December 31 whereas most of David's figures are based on a May 27 rebalancing. The ten-stock Beating the TSE portfolio is composed of the ten highest yielding stocks in the TSE 35. The one-stock portfolio is created by sorting the ten high yielders by price and then selecting the second lowest priced stock. The four-stock portfolio is created by sorting the ten high yielders by price and then selecting the second through fifth lowest priced stocks with double amounts of the second lowest. Readers of David Stanely's fine articles and the "foolishly inclined" (www.fool.com) should recognize these common variants. On the whole, the Beating the TSE approach has proven profitable in the past. It also beats the VR approach in the ten-stock portfolio case, but it is not nearly as good when it comes to smaller portfolios.

The one stock VR approach exhibits extraordinary returns but with very high volatility. The dangers inherent in a one-stock method are revealed in the historical returns of the one-stock Beating the TSE portfolio. In the period between 1990 and 1993 someone following this method would have lost over 50%. It might be considered a nearly Herculean feat to stick with a method after such a ghastly run. Although it hasn't happened, the one-stock VR method cannot be said to be immune from such occurrences. Therefore, both one-stock methods should be considered only by plungers or new investors who only want to buy one stock for trial purposes.

The objection might reasonably be raised that the healthy returns posted by the VR approach may be due to the stellar returns of the best VR stock (i.e. the 1991 & 1997 one-stock returns). To investigate this possibility two portfolios were created. The first, with average gains 16.68% per year, was composed of the second through fifth lowest VR stocks. The second, with average gains of 15.10% per year, was made by selecting the third through fifth lowest VR stocks. This result reduces the fear that the figures presented in Table 2 are overly biased by the amazing 70-80% one-stock returns of 1991 and 1997.

Average annual results for portfolios with one through to ten stocks with the lowest VRs are presented in Table 3. The clear trend to lower returns for larger portfolios may reflect the inclusion of less attractive value stocks in the larger portfolios. A portfolio size of ten represents almost one third of the TSE 35 and it seems unlikely that a third of this index represents good value at any given time. For investors desiring larger portfolios the TSE 60 is an obvious alternative.

It is now time to throw a bit of cold water on the VR approach with the immortal words of Benjamin Graham:
"The moral seems to be that any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last." - The Intelligent Investor.
To my mind this quote nicely encapsulates the problem with stock picking methods in general. Additionally, the figures presented here are subject to a possible start and stop date bias. That is, the results may be different when different portfolio rebalancing dates are chosen. Furthermore, one would also like to test the approach with a more substantial data record, but unfortunately the TSE 35 hasn't been around for very long. As well, there is always the very real danger that past results may be a poor predictor of future returns. A few other potential problems and uncertainties come to mind but Graham's objection is perhaps the strongest. Nonetheless, the strength of value investing has persisted for very long periods and the behavioral factors that give rise to it are unlikely to dissipate. As a result, I expect that the VR approach should be of value to investors, at least until too many hop on the bandwagon.

Table 2: Comparison of annual total returns for the Value Ratio, Beating the TSE and indexing approach.
Year Value Ratio

Beating the TSE 35

TSE 35
10 Stock 5 Stock 1 Stock 10 Stock 4 Stock 1 Stock  
1988-1989 15.13 23.03 13.81 14.16 7.41 12.10 11.32
1989-1990 17.91 19.02 22.59 20.01 19.55 32.49 21.89
1990-1991 -10.27 -0.51 5.97 -9.76 -13.66 -24.69 -11.65
1991-1992 33.48 46.86 79.56 30.21 18.36 -12.63 11.01
1992-1993 -1.44 -3.02 -25.93 -2.04 -6.06 -25.93 -3.58
1993-1994 17.44 12.15 28.83 26.47 27.49 28.83 24.34
1994-1995 -1.01 -2.21 1.84 3.24 3.40 5.02 5.52
1995-1996 11.55 14.84 6.54 14.18 10.94 7.56 14.47
1996-1997 31.57 31.02 15.34 38.10 36.62 23.63 30.01
1997-1998 30.75 48.63 72.94 26.66 40.50 72.94 16.38
1998-1999 -3.13 -6.59 -9.68 0.98 -5.99 -15.86 -0.09
1999 to Sept 3 7.52 27.47 40.97 8.03 21.51 40.97 15.53
Average : 12.55 17.29 20.57 14.19 13.34 12.04 11.26
High : 33.48 48.63 79.56 38.1 40.5 72.94 30.01
Low : -10.27 -6.59 -25.93 -9.76 -13.66 -25.93 -11.65
Growth : 3.72x 6.06x 6.98x 4.48x 3.95x 2.67x 3.37x
Beats the TSE35 : 6 / 12 8 / 12 7 / 12 8 / 12 5 / 12 5 / 12  

Table 3: Average annual returns versus VR portfolio size.
# Stocks : 10 9 8 7 6 5 4 3 2 1
Average : 12.46 12.57 14.22 14.62 15.11 17.56 17.89 20.39 21.23 21.06
1 Year Max : 33.48 33.24 35.65 40.80 42.99 48.63 50.34 62.77 66.62 79.56
1 Year Min : -10.27 -9.66 -9.07 -9.38 -7.43 -6.59 -9.57 -8.43 -14.96 -25.93
Growth : 3.72x 3.77x 4.42x 4.54x 4.77x 6.06x 6.23x 7.78x 8.07x 6.98x


First published in October 1999.
  MoneySense Articles
 Cdn Top 200 2016
 US Top 500 2016
 Retirement 100: 2015
 Cdn Top 200 2015
 US Top 500 2015
 Retirement 100: 2014
 Cdn Top 200 2014
 US Top 500 2014
 Retirement 100: 2013
 Cdn Top 200 2013
 US Top 500 2013
 Retirement 100: 2012
 Buffett Buys
 FB IPO
 Stocks that pay
 Value in the S&P500
 Cdn Top 200 2012
 US Top 500 2012
 Retirement 100: 2011
 Where to invest $100k
 Where to invest $10k
 Summer Simple Way
 A crystal ball for stocks?
 Cheap & safe
 Risky business
 Cdn Top 200 2011
 US Top 500 2011
 Retirement 100
 Dividend investing
 Value investing
 Momentum investing
 Low P/E P/B
 Dividends
 Dividend growers
 Cdn Top 200 2010
 US Top 500 2010
 Graham's prescription
 Income 100: 2009
 The case for optimism
 Cdn Top 200 2009
 U.S. Top 500 2009
 Wicked investments
 Simply spectacular
 Income 2008
 Small stocks, big profits
 Cdn Top 200 2008
 US Top 500 2008
 Value that sizzles
 So simple it works
 Income 100
 No assembly required
 Investing by the book
 Cdn Top 200 2007
 US Top 500 2007
 Invest like the masters
 A simple way to get rich
 Top Trusts 2006
 Stocks for cannibals
 Car bites dogs
 Cdn Top 200 2006
 US Top 1000 2006
 So easy, so profitable
 Top Trusts 2005
 Dogs of the Dow
 Top 200 2005
 Money for nothing
 Yield of dreams
 Return of the master

MoneySaver Articles
 2 Graham Stocks for 2017
 3 Stingy Stocks for 2016
 5 Graham Stocks for 2016
 3 Stingy Stocks for 2015
 3 Graham Stocks for 2015
 3 Stingy Stocks for 2014
 4 Graham Stocks for 2014
 8 Stingy Stocks for 2013
 6 Graham Stocks for 2013
 9 Stingy Stocks for 2012
 8 Graham Stocks for 2012
 Simple Way 2011
 5 Stingy Stocks for 2011
 7 Graham Stocks for 2011
 Simple Way 2010
 5 Stingy Stocks for 2010
 8 Graham Stocks for 2010
 Simple Way 2009
 Timing Temptation
 19 Stingy Stocks for 2009
 4 Graham Stocks for 2009
 Simple Way 2008
 Active at Passive Prices
 Unbundling ETFs 2008
 5 Stingy Stocks for 2008
 5 Graham Stocks for 2008
 Is your index too active?
 Graham's Simple Way
 Canadian Graham Stocks
 5 Stingy Stocks for 2007
 8 Graham Stocks for 2007
 Top SPPs
 The Simple Way
 A hole in your IPO?
 Monkey Business
 8 Stingy Stocks for 2006
 Graham Stock Gainers
 Blue-Chip Blues
 Are Dividends Safe?
 SPPs for 2005
 Graham's Simplest Way
 Selling Graham Stocks
 RRSP Money Market Funds
 Stingy Stocks for 2005
 High Performance Graham
 Intelligent Indexing
 Unbundling Canadian ETFs
 A history of yield
 A Dynamic Duo
 Canadian Graham Stock
 Dividends at Risk
 Thrifty Value Stocks
 Stocks in Short Supply
 The New Dividend
 Hunting Goodwill
 SPPs for 2003
 RRSP: don't panic
 Desirable Dividends
 Stingy Selections 2003
 10 Graham Picks
 Growth Eh?
 Timing Disaster
 Dangerous Diversification
 The Coffee Can Portfolio
 Down with the dogs
 Stingy Selections
 Frugal Funds
 Graham Revisited
 Just Spend It
 Ticker Temptation
 Stock Mortality
 Focus on Fees
 SPPs for the Long Term
 Seeking Solid Stocks
 Relative Strength
 The VR Approach
 The Irrational Investor
 Value Investing

Globe & Mail Articles
 Indexing advice
 Media-shy stocks
 Curse of size
 Market uncertainty
 Be even lazier
 Scary beats safe
 Small, illiquid, value
 Use the numbers
 What value is good value?
 Sculpt for value
 Value vs CAPE
 Graham Rules
 CAPE vs PeakE
 Top value ratio
 Low Beta
 Value and dividends
 Walter Schloss
 Try unloved AIG
 Why I'm a value investor
 New world of ETFs
 Low P/Es possible
 10 yielders
 Be happier
 Long-Short
 Dividend Downside
 Shiller's P/E
 Copycat investing
 Cashing in on class
 Index roulette
 Theory collides
 Diving too deep
 3 retirement villains
 Scourge of inflation
 Economic omens
 Analyst Expectations
 Value stock scarcity
 It's all in the index
 How to pick good funds
 Low Beta Wins
 Hunt for dividend stocks
 Think garage sale

Advisor's Edge Articles
 Passive Rebundling
 Doing the math

Norm Speaks
Flip Books

Tools:
 Asset Mixer
 Periodic Table
 ETF Fee Calculator



 
About Us | Legal | Contact Us
Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...