Value investors like to buy discounted stocks and they spend their days rooting through the market's half-off bin. But they have to be wary because, much like dollar-store specials, the bargains can be illusory.
When sizing up stocks, many value investors focus in on book value. It represents a company's total assets minus all of its liabilities. Book value can be thought of as a rough – and admittedly imperfect – estimate of a company's net worth.
Bargain hunters prefer stocks that trade at low prices compared with their book values and like to screen for firms with low price-to-book-value ratios (P/B). While such screens can reveal interesting stocks, they are not without their pitfalls.
On the plus side, buying low-P/B stocks has been profitable over the very long-term according to James O'Shaughnessy's book What Works on Wall Street. In one study he sorts U.S. stocks by P/B each year, splits the list into 10 equal groups called deciles, and tracks their performance over time.
Stocks in the lowest-P/B group gained an average of 11.3 per cent annually from Jan. 1, 1927, to Dec. 31, 2009. They beat the market, which climbed 10.5 per cent annually over the same period.
However, stocks with the next-to-lowest ratios took top spot in the performance race with average annual returns of 12.7 per cent.
Problem is, there were lengthy periods when low-P/B stocks didn't fare well. For instance, the lowest-ratio group climbed by 7.5 per cent annually from Jan. 1, 1927, to Dec. 31, 1963. But it lagged the market by 2.0 percentage points a year. The poor relative performance was largely the result of the shellacking the low-ratio stocks took when the market collapsed in 1929.
(As an aside, it is unwise to bet on the highest-P/B group because it underperfomed in both time periods and only rarely beats the market.)
The uneven history of low-P/B stocks won't come as a big surprise to Canadian value investors because the ratio hasn't fared well north of the border.
Travis Fairchild, also of O'Shaughnessy Asset Management, reported that the lowest-P/B decile of Canadian stocks lagged the market by 0.7 of a percentage point a year from 1987 to 2013. Once again, stocks in the second lowest group fared better. They beat the market by 2.2 percentage points a year. (At the other end of the spectrum, stocks with the highest ratios trailed the market by a whopping 5.1 percentage points annually.)
While the returns generated by low-P/B stocks in the U.S. have been inconsistent over the years, the Canadian experience hasn't been good in recent times. That's largely due to the nature of our market.
To see what's going on, I took a look at the output of a simple low-P/B screen this week. The lowest-P/B decile in Canada currently contains stocks that trade for less than 0.32 times book value. Problem is, it's a rare day when a viable Canadian company trades for less than one third of book value – and those days usually happen after big market crashes.
Looking closely, more than 90 per cent of the companies that pass the low-ratio test operate in the energy and materials sectors. In addition, the vast majority of them trade for less than $1 a share, are unprofitable, and are unlikely to become profitable any time soon.
In other words, the lowest-P/B group is crammed full of junior mining and oil stocks that should generally be avoided. (When the screen is limited to the largest 40 per cent of companies in Canada the low-ratio group is still dominated by energy and mining concerns.)
Don't get me wrong, screening for low-P/B stocks can be useful. But it's far from perfect and it should be supplemented with other factors.
As a result, caution is required when rummaging around the market's bargain bin.