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The Value 60 Approach

Value investing uses fundamental data about a stock to determine if it is priced correctly in the market. Information about a company's earnings, dividends, assets and other characteristics are of primary importance to the value investor. Stocks that are trading at low prices in comparison to a company's fundamentals are of particular interest. The value approach can be psychologically trying since value investors often find themselves going against the crowd and shying away from the current market darlings. Fortunately for the value investor, "ugly duckling" stocks are often priced at levels lower than their long term value and represent good buying opportunities.

A number of studies have determined that the value approach has performed well historically and it is useful to review some of these findings (See Table1). David Dreman's investigation of fifteen hundred of the largest stocks in the United States during the period between 1970 and 1996 was described in his book Contrarian Investment Strategies: The Next Generation. Specifically, Dreman looked at the performance of stocks in comparison with their price-to-earnings (P/E), price-to-book (P/B), price-to-cash flow (P/C) and the price-to-dividend (P/D) ratios. These ratios are all based on the stock's price per share and one fundamental financial aspect of the company on a per share basis. The fundamentals in question are the company's net earnings, book value, operating cash flow and dividend payout. A company's net earnings are a measure of its profits after all expenses. Book value describes how much a company's assets are worth including such things as the value of the company's property, equipment and investment in other companies. Operating cash flow describes how much money the company generates from its operations as opposed to money taken in from other sources such as the issuance of new debt. Dividend payout is the amount of money a company pays out, on a regular basis, to its shareholders. Since most investors are interested in buying a portion of the company, the fundamental factors are divided by the number of shares outstanding thereby putting them on a per share basis. The ratios are then calculated by dividing the current price per share by the value of the fundamental in question on a per share basis. For instance the price-to-earnings ratio is calculated by dividing the current price per share by the stock's earnings per share. Dreman tests each ratio by splitting up his group of fifteen hundred stocks into five equal portions called quintiles with quintile one formed from the group of stocks with the lowest ratios all the way up to up to quintile five containing stocks with the highest ratios (See Table 2). There is a clear tendency for low ratio stocks to outperform both the average and their high ratio counterparts by a large margin. The simple lesson Dreman teaches is that investors should seek out low-ratio issues to buy.

Table 1: Selected Value Investing Books
Book Author
Contrarian Investing Strategies: The Next Generation David Dreman
What Works On Wall St, Revised Edition James O'Shaughnessy
The Intelligent Investor Benjamin Graham

Table 2: Dreman's Results- Total Annual Returns from 1970 to 1996.
Quintile P/E P/B P/C P/D
1 (Low) 19.0 % 18.8 % 18.0 % 16.1 %
2 17.4 % 16.3 % 16.6 % 17.5 %
3 14.6 % 14.6 % 15.8 % 15.1 %
4 13.1 % 13.7 % 13.7 % 13.8 %
5 (High) 12.3 % 12.0 % 11.2 % 12.2 %
Average 15.3 % 15.1 % 15.1 % 14.9 %

James O'Shaughnessy investigated many value ratios in his book What Works On Wall Street including the price-to-sales (P/S) ratio. The P/S ratio is formed by dividing the current price per share by the value of the company's sales (or gross revenue) per share. O'Shaughnessy studied the large stocks in the U.S. S&P Compusat database from 1951 to 1996 and looked at a variety of investment strategies by tracking either the fifty highest or lowest ratio stocks in the sample (See Table 3). For instance the Low-P/E strategy represents the approach of buying the lowest fifty P/E stocks in the group at the beginning of the year and then replacing them at the end of the year with the lowest fifty P/E stocks at that time. O'Saughnessy's findings reveal that in the five periods studied the low-ratio strategies almost always outperform the average. Disappointments occurred in the 1980s when the low-P/E strategy gained 16.19% (versus the 16.89% average) and in the 1950s when the low-P/D (or high dividend yield) approach disappointed by providing a return of 15.20% (versus the 15.33% average). However, overall, the low-ratio approaches outperformed in 92% of all tests. On the other hand, the high-ratio approaches beat the average on only 7 out of 20 occasions (or in 35% of the tests) and generally performed miserably. Again low ratios have been shown to improve portfolio performance and conversely high ratios have had a negative effect on performance.

Table 3: O'Shaughnessy's Results- Compound Annual Return from 1951 to 1996.
Strategy 1950s 1960s 1970s 1980s 1990s
Low P/E 16.12% 11.14% 12.64% 16.19% 15.25%
High P/E 14.77% 10.94% 0.93% 14.11% 9.21%
Low P/B 15.41% 9.57% 13.95% 19.99% 15.85%
High P/B 16.55% 11.30% -0.60% 14.40% 13.92%
Low P/C 17.28% 10.36% 15.40% 17.31% 16.49%
High P/C 14.85% 12.35% -1.85% 13.29% 14.53%
Low P/S 16.39% 9.48% 10.90% 20.09% 14.84%
High P/S 13.21% 11.73% 3.23% 9.54% 12.50%
Low P/D 15.20% 9.82% 11.44% 17.15% 13.65%
Average 15.33% 8.99% 6.99% 16.89% 12.61%

The Value 60 Approach focuses on the Canadian stock universe as represented by the sixty blue chip stocks in the S&P/TSE 60 index. The stocks in this index are ranked to determine which have low P/E, P/B, P/S, P/C and P/D ratios. The ranking process will be illustrated by detailing the steps used to determine the P/E rank. The first step is to assign all stocks that have negative P/E ratios the lowest rank which is zero. Companies with negative P/E ratios have negative earnings (ie. they lost money) and may represent speculative opportunities but are of little interest to the conservative investor. Stocks with positive earnings are then arranged in order of low to high P/E ratios and split into five equal groups. The lowest P/E group is given the highest rank of five and the highest P/E group is given the rank of one. Naturally, a high rank is considered to represent good value for the conservative investor. A similar ranking process is repeated for the four other value ratios and each rank is added up to form a score which ranges from zero to twenty five. Stocks with high scores are under-valued and those with low scores are over-valued or more speculative. To provide more quantitative direction, stocks with scores of twenty or more represent prime candidates for purchase whereas those with scores of ten or less should be considered for removal from a conservative portfolio. It is important to keep in mind that one of the largest draws on portfolio performance is the cost associated with trading. As a result the conservative investor should only consider trading about once a year or if a stock that once had a high score (twenty or more) declines significantly (to ten or less) during the year.

Bullishly Yours,
Norman Rothery

Special Note:

Financials are treated differently as their sales and cash flows from operations are not good measures. Instead their total score is determined by ignoring the P/S & P/CF rank but doubling up the P/E & P/B rank. This modification should more accurately reflect the health of financial stocks.
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