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Traders work on the floor of the New York Stock Exchange May 29, 2014. (BRENDAN MCDERMID/REUTERS)
Traders work on the floor of the New York Stock Exchange May 29, 2014. (BRENDAN MCDERMID/REUTERS)

Investors are ignoring the most historically accurate way to pick winning stocks Add to ...

It’s odd but true: Investors are choosing to ignore one of the most historically accurate ways to pick winning stocks.

An impressive stack of research shows stocks that trade at low prices in comparison to their book values tend to go on to produce better returns than the overall market. Yet many people couldn’t care less about this yardstick–as shown by the recent rise of stocks like Tesla, Facebook and Netflix, all of which trade at stunningly high multiples of their book values.

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The buyers should pause and read the work of Eugene Fama of the University of Chicago and Kenneth French of Dartmouth. In a now classic 1992 paper, the two men divided U.S. stocks into 12 groups on the basis of their price-to-book ratios and found their place on that scale to be an amazingly accurate predictor of their future returns. Stocks with low price-to-book ratios did best; stocks with higher price-to-book ratios fared worse.

Despite this clear evidence, the notion of measuring stocks by their book value has been shunted into obscurity, like an embarrassing antique that gathers dust in the attic.

Book value is the difference between a company’s assets and its liabilities. If a company sold off all its assets at their value on the balance sheet and paid off all its liabilities, at their recorded value, then book value would be what would be left over.

Price-to-book’s fall from popularity is partly due to bad timing. It had the misfortune to be shown effective as an investing tool just as tech stocks roared into public consciousness–which hammered the conviction that old-fogey notions like hard physical assets and book value mattered any more. Fama and French’s paper was based on stock returns between 1963 and 1990.

To be fair, the skeptics raise some good points. One problem is that the values of assets on the balance sheet re-flect the price at which they were acquired. Those amounts have no necessary connection to their current market value. Book value also can underplay intellectual property, like patents. When assessing Internet or e-commerce stocks, book value often misses the point.

Okay, the yardstick isn’t perfect–but it’s still darn effective. A study by Aswath Damodaran of New York University picked up where Fama and French left off, and found that a policy of buying low price-to-book stocks would have continued to beat the market between 1991 and 2010.

So how do you best use book value? It’s most effective when you size up similar companies within a sector, rather than compare ones in dissimilar industries. The fact that Goldcorp was recently selling for 1.1 times its book value while rival gold miner Barrick was trading at 1.5 times book makes me think that Goldcorp might be the better value. But just because both miners have far lower price-to-book ratios than Google is no guarantee that they’re better investments.

Price-to-book ratios are most telling when a company is selling at a low multiple compared to its own history, and when its return on equity continues to be strong. That combination suggests the business is still healthy, but undervalued–and therefore a potentially good buy.

Look for companies that fit the bill right now and you see names like Agrium, Goldman Sachs and RioCan REIT. To those few of us retail investors who still believe in book value, these unloved stocks are far more attractive than the market’s current crop of high fliers.

Follow on Twitter: @IanMcGugan

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