Bull markets test the mettle of cautious investors who find themselves left behind as stocks race higher. The temptation to buy high in an effort to join the fun can be overwhelming.
It's an urge that absolute value investors face with some regularity. They refuse to pay more for a stock than they think it's worth. As a result, they generally move heavily into cash well before the market loses steam.
Relative value investors take a slightly different view. They try to buy the cheapest stocks in the market and stick with them through thick and thin. But they suffer the full brunt of any downturns that materialize.
The divergence between the two methods increases in good times, which can be demonstrated using a simple screen inspired by money manager Benjamin Graham's book, The Intelligent Investor.
In the book Mr. Graham pointed defensive investors to stocks with price-to-earnings ratios (P/E) ratios of 15, or less, and price-to-book-value ratios (P/B) ratios of 1.5 or less.
But he was willing to be a little flexible when one ratio was too high, provided the other ratio was low enough. To account for such cases he required the product of the two ratios to not exceed 22.5.
I've used the combined ratio technique for years and apply it regularly to the 60 stocks in the S&P/TSX 60 index, which tracks some of the largest and most well-known firms in Canada.
As you might imagine, the number of stocks that pass the test varies dramatically depending on the state of the market. Thirty-one of the 60 stocks passed Mr. Graham's test at the end of 2008 when the financial system was in acute distress. But that number has been getting smaller and smaller ever since.
This week, only six stocks passed the test. They are Teck Resources, Manulife Financial, Brookfield Asset Management, Power Corp., National Bank of Canada and Bank of Montreal, according to data from S&P Capital IQ. (I own a few shares in Manulife and Bank of Montreal.)
The stock with the lowest product of ratios is Teck Resources, which trades at only 0.8 times book value and a somewhat lofty 21.1 times earnings.
By way of comparison, the most expensive stock in the index, based on the product of its ratios, is SNC-Lavalin, which trades at roughly 111 times earnings and 4.1 times book value.
Mr. Graham's approach is geared to absolute value investors because it sets specific limits. But it's easy for relative value investors to use the product of the ratios too. Instead of setting their cutoff at 22.5, they can specify the number of stocks they want to buy – say 10 – and snap up the cheapest ones. As a result, they won't run out of stocks, no matter how high the market goes.
If you're keen on taking such an approach, the four additional stocks needed to round out a 10-stock portfolio are Sun Life, Canadian Tire, Suncor Energy and Agrium. (Be sure to do your own research before deciding on buying any stock.)
The valuation difference between the sixth and seventh stocks on the list – the point deemed to be too expensive for Mr. Graham – isn't huge.
Bank of Montreal is the sixth-cheapest stock and it trades at 12.2 times earnings and 1.7 times book value. The seventh is Sun Life and it can be had for 14.5 times earnings and 1.6 times book value.
Whether the difference is big enough to stay in cash instead of investing in Sun Life is a matter of personal preference. But, at some point, value investors have to be willing to say no.
After all, buying the cheapest stocks in Japan at the height of their bubble in 1989 probably didn't work out too well. They might have outperformed the market, but that just made them the prettiest corpses in the morgue.