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A yardstick identified strong companies whose annual returns were even greater than low price-to-book stocks. (Natalia Lukiyanova/Getty Images/iStockphoto)
A yardstick identified strong companies whose annual returns were even greater than low price-to-book stocks. (Natalia Lukiyanova/Getty Images/iStockphoto)

Value Stocks

Deep-value investing: Bargain hunting need not be a crap shoot Add to ...

Lots of investors like to find promising stocks by screening a database for companies that meet certain criteria. But what happens when the names that turn up are too distressing to stomach?

That’s the dilemma facing deep value investors, who like to buy stocks that are unusually cheap – and therefore may have more than their share of problems.

Several research studies suggest that you should avoid the temptation to cherry pick the results of a stock screen. Attempts to improve portfolio performance by weeding out winners from losers generate little additional value.

But for a deep value investor in Canada, this all-inclusive approach poses problems.

Whatever the selection criteria you use, the end result of a bargain-hunting screen will likely be a list of stocks that are best described as “dogs with hair on them.”

It’s difficult to contemplate the thought of all those ugly names in your portfolio – but a portfolio strategy that is difficult to execute isn’t really a strategy at all.

Fortunately, the problem with distasteful value stocks isn’t confined to Canada and a website inspired by the classic value investor Benjamin Graham has a solution.

After an initial screen based on stock valuation criteria, his website, grahaminvestor.com, suggests an investor should then run a second screen to identify financially strong candidates and invest only in those companies. To identify strong companies, the site recommends the Piotroski scoring system.

In 2002, Joseph Piotroski, who at the time was an associate professor at the University of Chicago, published a research paper that examined the performance of low price-to-book-value stocks.

He found that, while the overall group outperformed the benchmark index, “the success of that strategy relies on the strong performance of a few firms, while tolerating the poor performance of many deteriorating companies.”

So, he looked for a few simple financial statement ratios that would differentiate weak and strong firms.

The nine ratios that he settled on are easy to calculate and black-and-white – a company either passes or it fails. A company is classified as strong if it passes eight or more of the following tests.

  • Net income: Most value companies are struggling. Score 1 if positive.
  • Cash flow from operations: A good measure of earning power. Score 1 if positive.
  • Change in return on assets (ROA): Score 1 if current-year ROA exceeds previous year’s.
  • “Managed Earnings”: Score 1 if cash flow from operations exceeds net income.
  • Change in leverage: Score 1 if the ratio of long-term debt to assets has declined year over year.
  • Change in current ratio: Score 1 if the current ratio (current assets divided by current liabilities) has increased year over year.
  • Share dilution: An undervalued company issuing additional shares is a sign of distress. Score 1 if the number of shares outstanding is no more than the total a year ago.
  • Improvement in gross margin: Potentially a sign of an improving business environment. Score 1 if the gross margin is up year over year.
  • Improvement in asset turnover: Potentially another sign of improving asset productivity. Score 1 if asset turnover has improved year over year.

Mr. Piotroski ranked companies based on the test scores and made a startling discovery. He found that portfolios made up of companies with a score of 8 or 9 (i.e. the strongest), delivered an annual return 7.5 percentage points greater than the overall universe of low price-to-book stocks – which was already a value investor’s dream.

Part of the incremental return came from small and mid-cap stocks with little analyst coverage, but it was not confined to this group alone.

These ratios are laborious to compute for a retail investor, but fortunately the grahaminvestor website provides a complete listing of stocks with a Piotroski score of 8 or 9. (Names seem to appear and disappear with alarming frequency, so exercise caution before accepting anything at face value.)

Canadian investors are fortunate that this database contains more than 100 TSX-listed stocks. Not all companies with a high Piotroski score are value investments, of course, so I looked for Canadian companies that trade below their book value per share and have a market capitalization of at least $100-million.

The six companies in the accompanying list qualify on the basis of second quarter 2012 financials and may disappear if there are year-end writeoffs, but the recent Piotroski score suggests that they combine value with financial strength.

Cheap and Chearful

Canadian stocks trading below book value, with market caps of $100-million or more, and Piotroski scores of at least 8.

  • Atrium Innovations (ATB-T)
  • Cascades Inc (CAS-T)
  • Sherritt International (S-T)
  • Delphi Energy Corp. (DEE-T)
  • Astra Technologies (AAH-T)
  • Vecima Networks (VCM-T)

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

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