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Number Cruncher

A marathon test for value stocks Add to ...

What are we looking for?

The pentathletes of the value-investing world. These are stocks that excel not just in one category that appeals to bargain hunters, but in several.

Our search for stocks that can score well on several value tests is inspired by money manager James O’Shaughnessy. In the recent update to his classic What Works on Wall Street, he argues that any single value indicator is likely to go through periods when it doesn’t work. A more robust strategy, in his opinion, is to look for stocks that satisfy several criteria.

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One approach Mr. O’Shaugnessy explores is to seek stocks that score highly on five classic tests of value. We applied his suggestion to stocks trading on the Toronto Stock Exchange and adapted his strategy by searching for stocks that:

– have a price-to-book ratio below one;

– have a price-to-sales-ratio below two;

have a price-to-earnings ratio below 10;

– have a price-to-cash flow ratio below 10;

– have enterprise value to EBITDA of less than six. Enterprise value is the total market value of a company’s stock and its net debt. EBITDA is earnings before interest, depreciation and amortization.

What we found

Only 21 stocks met our criteria. Several are small cap or micro-cap firms that may be too risky for some investors’ tastes. On the other hand, the list also contained several big to giant firms – notably the smartphone maker Research In Motion and the miner Sherritt International

It’s important to note that stocks tend to be cheap for good reasons. You should do your own research before buying any of these value pentathletes. But Mr. O’Shaugnessy’s research indicates that stocks that excel in all five categories have a habit of doing better over time than the broad market.

His back test selected U.S. stocks that scored well on all five criteria. Between 1964 and 2009, they produced an annual average return of 17.2 per cent compared to 11.2 per cent for the broad market. In the market marathon, these pentathletes shine.

Full disclosure: I own shares in Algoma Central.

Follow on Twitter: @IanMcGugan

 
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