The simplest way to select bargain stocks

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The stock market can act like a demented Rube Goldberg machine designed to confound investors. But clear away the complexity and it offers some simple methods that perform surprisingly well over the long run.

One was revealed by the late Benjamin Graham in a 1976 article called The Simplest Way to Select Bargain Stocks. The famous money manager calculated that his method would have generated 15-per-cent average annual returns over the prior 50 years.

More impressively, the technique lost none of its potency after being shown to the world. That's according to money managers Wesley Gray and Tobias Carlisle who revisited it in their book Quantitative Value. They figure that those who followed the approach would have gained an average of 17.8 per cent annually from 1976 through 2011.

Mr. Graham prescribes investing in stocks with little debt and low price-to-earnings ratios (P/E). Money manager John Dorfman took the advice to heart and has been tracking such stocks in his robot portfolio for almost two decades. He announced earlier this month that the robot portfolio had gained an average of 15.6 per cent annually over the past 17 years. It far outpaced the S&P 500, which climbed at an annual rate of 4.2 per cent over the same period.

I hasten to add that the outsized returns came with a dollop of volatility. For instance, Mr. Gray and Mr. Carlisle figure that the low-debt low-P/E portfolio they tested had an annual volatility (standard deviation for the statistically inclined) of 23.9 per cent from 1976 to 2011. It exceeded the S&P 500's volatility, which came in at 15.4 per cent over the same period.

Turning to the nitty-gritty, Mr. Dorfman's robot portfolio focuses on U.S. stocks with market capitalizations of $500-million (U.S.) or more and debt-to-equity ratios of less than one. Each year, it picks the 10 candidates with the lowest price-to-earnings ratios.

It's an easy matter to import the technique into Canada. The current list of stocks on the TSX that pass the test, according to data supplied by S&P Capital IQ, contains a few firms that are a little rough around the edges. You can examine the full list in the accompanying table.

SNC-Lavalin is the cheapest of the bunch at about four times earnings. The Quebec-based engineering firm was caught up in a bribery-related scandal but appears to be reforming itself.

Dream Unlimited is a real estate investment firm based in Toronto that trades at 4.4 times earnings. Its slumping stock has produced a few sleepless nights for shareholders over the past year. But analysts remain bullish on its prospects.

Speaking of nightmares, mortgage insurer Genworth MI Canada trades at about six times earnings. The Oakville, Ont.-based firm's shareholders have been fretting over the faltering property market in Alberta. Visions of a real estate apocalypse helped to push its dividend yield to a lofty 7.2 per cent.

Shares of Transcontinental, a Montreal-based printing firm, advanced over the past year despite the bear market. Yet the stock changes hands at only six times earnings and pays a 3.8-per-cent dividend yield.

Sleepy E-L Financial is a thin trader that goes for six times earnings. It also happens to be a personal holding. The insurance-focused conglomerate is controlled by the Jackman family and trades at a sharp discount to its net equity value.

The other members of the list are WestJet Airlines, Brookfield Canada Office Properties, Westshore Terminals, Power Corp., and Canfor Pulp, which all go for less than eight times earnings.

In the interests of full disclosure, I recently purchased shares of financial conglomerate Power Corp. for my own account. The stock pays a dividend yield of 4.3 per cent and trades near book value. It last saw similar price-to-book value levels during the crash of 2008-09.

While it is an easy matter to find stocks Mr. Graham might have loved, sticking with the approach through thick and thin can be difficult.

It's one reason why low-ratio stocks have generated good returns for decades.

Norman Rothery is the value investor for Strategy Lab. Globe Unlimited subscribers can read more in the series at tgam.ca/strategy-lab.