How to find great bargains in the stock market

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Halloween brought back fond memories of rushing from door to door for treats. And how, after returning home, I had some serious decisions to make.

I would begin with a careful inspection of my haul, then a methodical sorting of the treats into different piles depending on their relative attractiveness. Some were devoured immediately while others were put away for another day. Less appreciated candies – like the dreaded Halloween kisses – were left unmolested for weeks.

While my trick-or-treating days are well behind me, I still display the same level of zeal when picking stocks. Great bargains can be found by sorting stocks into piles using different measures of financial merit.

The best measures to use are often taken from U.S. studies. But the Canadian market is highly concentrated in financial and resource stocks and might not behave in exactly the same way as the U.S. market. That's why I was interested to see the results of study done by Dartmouth professor Kenneth French that looks at the performance of four popular value indicators in the Canadian stock market.

He started with the humble price-to-earnings ratio (P/E), which compares a stock's price to its earnings over the past 12 months. It's a wildly popular metric because sensible investors always prefer to buy the most earnings for the least amount of money.

But earnings aren't everything. Some investors want to keep a close eye on the cash that flows into a company. They focus on price-to-cash-flow ratios (P/CF) and prefer stocks that generate a lot of cash compared with their market values.

Other investors track price-to-book-value ratios (P/B), which measure how expensive a company is relative to its net assets (assets less liabilities). The ratio is beloved by academics because book values don't vary as much as earnings over the short term.

Dividend yield is the last, but certainly not least, of the four indicators Prof. French considered. Income investors cherish stocks that pay generous dividend yields and, right now, the low interest rate environment makes dividends particularly appealing.

To determine the winner of the Canadian performance race, I turned to the data collected by Prof. French. For each indicator, he looked at how two different portfolios would have performed – one that held the 30 per cent of stocks with the highest values for that indicator, another that held the 30 per cent of stocks with the lowest values.

His results are displayed in the table below, which shows the average annual returns of both high, and low, ratio stocks from Jan. 1, 1977, to Dec. 31, 2012. By way of comparison, the market as a whole gained 10.3 per cent over the period.

As you can see, the portfolios with low ratios or high dividend yields all beat the market. Buying stocks that deliver value, by one standard or another, has clearly been a winning strategy over the past three decades.

The top spot was taken by the highest yielding stocks, which gained 15 per cent a year on average. They bested the 9.4-per-cent annual returns of the low-yield stocks.

And how about stocks that don't pay dividends at all? Prof. French tracked this group and found they took home the booby prize with average gains of only 3.6 per cent a year over the same period.

The lesson is clear: Non-dividend payers are best avoided in Canada. Similarly, high-ratio stocks should be given a wide berth.

However, it is important to keep in mind that the winner of the performance race tends to change over time. High-yield stocks are at the top of the heap today, but they might be replaced by, say, low-P/E stocks next year.

That's why savvy investors use several factors when deciding which stocks to invest in. For instance, they might opt for low-P/E stocks that also pay above-average dividend yields.

Keep an eye on these simple but powerful measures of value and you might be able to put more treats into your portfolio.

Data source: Kenneth French, average annual returns shown