Cheap stocks with Street cred

What are we looking for?

Cheap and cheerful stocks: cheap because they're selling at low prices relative to their book values; cheerful because analysts are raising estimates for their earnings.

More about today's screen

Many value investors snap up stocks selling at low prices compared to their book values on the theory that these cheap shares will produce superior returns over time. But the more you examine the evidence for this strategy, the more mixed the results appear to be.

Craig McGee, senior consultant at CPMS, a division of Morningstar Canada, crunched the numbers for the Canadian market. He looked at how an investor would have done if she or he had made a habit of buying the 25 stocks with the lowest price-to-book values on the TSX composite index, refreshing the mix every three months.

The results were disappointing: The low P/B strategy generated an annualized return of only 1.6 per cent since 1986. By comparison, the S&P/TSX composite Total Return Index returned 8.4 per cent over the same period.

So Mr. McGee tried an interesting variation: He looked at how an investor would have done by buying the lowest P/B stocks that also had positive changes in consensus earnings estimates over the previous three months. These are stocks that are not only cheap, but are also improving their performance in the eyes of analysts.

More about CPMS

CPMS provides quantitative North American equity research and portfolio analysis to primarily institutional clients.

It covers more than 700 Canadian and 2,200 U.S. stocks, and spends a great deal of time adjusting for unusual accounting items in each company's quarterly results to make sure screens can perform correctly.

What we learned

The revised strategy performed much better, producing an annualized return of 15.2 per cent since 1986.

The new approach also limited losses. While the biggest single drawdown on the low P/B strategy was an agonizing 71 per cent of the portfolio's value, the worst drawdown on the low-P/B-plus-improving-expectations strategy was a somewhat less painful 39 per cent.

As usual, though, no strategy provides a highway to guaranteed success. While the combined strategy was the hands-down winner over the past 26 years, it has lagged over the past five years, producing annualized profits of 6 per cent compared to 7.8 per cent for the simple low P/B approach.