Value and quality are usually found at opposite ends of the stock market. After all, good businesses usually trade at high prices, while the market's bargain bin is littered with ailing firms.
For investors, this raises a question: Should you scoop up the cheapest bargains in the market, or insist on quality when picking stocks?
I believe that value comes first. Despite their apparent ugliness, bargain stocks do quite well, as a group, due to their low prices.
But some of them deserve to trade for even less. That's why many value investors look at business quality in an effort to find stocks that are both cheap and relatively safe.
There are several ways to incorporate quality into a value portfolio that seem to work reasonably well. Money managers Wes Gray and Tobias Carlisle outlined one approach in their recent book Quantitative Value.
They think the best way to find good value stocks is to look for those with the highest ratio of earnings before interest and taxes (EBIT) to enterprise value (EV). The higher the ratio, the more cash a company is generating in comparison to the market value of its equity plus net debt.
Buying stocks with high EBIT-to-EV ratios has worked extraordinarily well over the long term. The money managers calculate that a portfolio holding the 10 per cent of large U.S. stocks with the highest multiples would have gained 16.0 per cent on average each year from 1974 to 2011. It would have handily outperformed the S&P 500, which gained only 10.5 per cent annually over the same period.
Given such fine results, many investors might be inclined simply stop right here. But Mr. Gray and Mr. Carlisle thought they could do better by adding a touch of quality.
One measure they favour for this purpose is the ratio of gross profits to total assets (GPA). The ratio compares a clean measure of corporate economic profitability to the assets needed to generate them. The stocks with the highest ratios are thought to have the best businesses.
Using GPA to pick stocks, on its own, was profitable for investors. Those with the highest 10 per cent of GPAs gained 12.6 per cent annually from 1974 to 2011 and bested the S&P 500 by 2.1 percentage points a year.
Unfortunately, Mr. Gray and Mr. Carlisle moved on from GPA to develop their own rather complicated formula for quality. They only touched on how well EBIT/EV and GPA work together when both factors were used equally. The results were still quite good but they narrowly failed to exceed those from using EBIT/EV on its own.
I wanted to use the ratios in a slightly different manner by putting value at the forefront and then adding a twist of quality at the end.
I started by scouring the TSX for medium-sized and large companies – those that had annual revenues in excess of $250-million. I then narrowed down my list to the cheapest names by keeping only the 10 per cent of firms with the highest EBIT to EV multiples. I further pruned the group by looking for the 10 per cent of the remaining stocks with the highest GPAs.
Three firms made the grade, according to S&P Capital IQ. They are Aastra Technologies (AAH), Coastal Energy (CEN), and Torstar (TS.B).
All three have different issues, which shouldn't come as a surprise because they're value stocks first and foremost. Quality was a secondary consideration.
For instance, given the declining nature of the newspaper industry, Torstar isn't what most people would call a quality business at this point. But it remains profitable and it could do better than expected should it adjust to the new realities of the marketplace. I hold a few of its shares in my personal portfolio.
Aastra Technologies, of Concord, Ont., makes desk phones and other communications devices for the business market. It might not be in the most glamorous business, but it has a large amount of cash on its balance sheet and pays a juicy dividend yield of 4.4 per cent.
Coastal Energy is an oil and gas firm with assets in Thailand and Malaysia, which could make it an exotic bet for some. But it has grown smartly over the years and should be of interest to those who don't mind taking a walk on the wild side.
While these stocks might not be for everyone, I believe value investors should take a closer look at them.