What are we looking for?
Benjamin Graham, the famed value investor, said the market is a weighing machine in the long run, but a voting machine in the short run. At times, it puts a bargain price on outstanding stocks, but only temporarily.
To test his observation, I went looking for highly profitable companies that appear undervalued.
I focused on highly profitable companies because a company's ability to consistently generate large earnings relative to its capital is strongly correlated to the price that investors will pay for it over the long haul. Companies that are highly and persistently profitable are also more likely to be winners over the next economic cycle.
When highly profitable companies have fallen to cheap levels, they're worth a close look.
How we did it
I looked for Canadian enterprises with at least $1-billion in market capitalization and a median return on equity (ROE) of at least 20 per cent over the past 10 years.
A 20-per-cent-plus ROE is unusually high and the ability to maintain it over a decade suggests a business has been able to consistently generate strong profits over a full economic cycle. But to ensure these companies aren't just riding on past glories, I required each stock on my list to have maintained its 20-per-cent-plus ROE in its most recent filing.
Based on my analysis of market history, a company with a 5 per cent ROE typically trades at about one times its book value (that's its net asset value for you non-accountants). A company with a 20 per cent ROE usually fetches a price about four times book.
In compiling my list, I looked for companies with both the 20 per cent ROE I mentioned above and a current price-to-book-value (P/B) ratio below four. This suggests it's undervalued.
What did we find?
The companies that made my list are all trading below the values you would expect of companies with their strong earnings history, usually because the market believes their profits or their growth are going to decline.
Each investor will have to arrive at his or her own judgment about whether the market's pessimism is warranted, but all of these companies have the odds in their favour. Those that can continue their profitable streaks are in a good position to reward their shareholders.