Deep-value investing is a powerful way to beat the market, but deep-value stocks are an endangered species in the U.S., according to money manager Patrick O'Shaughnessy. The situation north of the border is similar. But, thankfully, there are still some bargains to be found.
Value investors use a variety of tools to ferret out cheap stocks. Mr. O'Shaughnessy recently went on the hunt for companies with low enterprise value (EV) to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratios.
That's a mouthful to be sure, but the ratio can be thought of as a fancier version of the more familiar price-to-earnings ratio. It replaces price with enterprise value (the market value of a company's equity plus net debt) and earnings by EBITDA. As with regular P/E ratios, value investors prefer stocks with low EV/EBITDA ratios.
Mr. O'Shaughnessy was inspired to use the ratio after talking to money manager Tobias Carlisle who recently published a new book called Deep Value. In it, Mr. Carlisle shows that stocks with the lowest 10 per cent of EV/EBITDA ratios gained 13.7 per cent annually from 1964 to 2011 and beat the S&P 500 by 4.2 percentage points a year.
But Mr. O'Shaughnessy also wanted to know how the population of U.S. deep-value stocks varied over time. To find out, he focused on reasonably-sized non-financial stocks and tallied up how many sported EV/EBITDA ratios of less than 5.
The fraction of stocks that passed his value test fluctuated over the years. There were several periods since 1963 when more than a third of U.S. stocks found themselves mired in deep-value territory, including a brief span just after the crash of 2008. The real heyday for these value stocks was during the late 1970s, and early 1980s, when inflation ran rampant and more than half the population passed the test.
These days, the situation is dramatically different. This month, only 3.2 per cent of non-financial stocks, with market capitalizations in excess of $200-million, were in the value camp. That's better than the all time low of 2.9 per cent seen in June, but the pickings remain slim.
Rather than seeing the glass as being almost 97 per cent empty, Mr. O'Shaughnessy noted that 65 U.S. stocks passed the low-EV/EBITDA test and highlighted three energy giants in particular. The value stars were ConocoPhillips, Hess Corp., and Marathon Oil Corp.
While the Canadian market is much smaller than the one south of the border, a larger proportion of our stocks pass Mr. O'Shaughnessy's value test. Currently about 6.2 per cent of the Canadian market is in value territory, according to S&P Capital IQ.
The largest value stock of the bunch is Toronto-based Pacific Rubiales Energy Corp., an independent oil and gas producer in Latin America. Its stock trades at an EV/EBITDA of 3.5 and it pays a generous dividend yield of 4.0 per cent. Despite a recent slump, its stock remains well above its March lows.
Another big value stock is Montreal-based Transcontinental Inc. It's a large commercial printer that churns out retail flyers, magazines, newspapers, books, and other marketing products. The firm's stock trades at an EV/EBITDA of 4.4 and it pays a 4.4 per cent dividend yield. In addition, it isn't shy about buying back its own stock and did so in late 2012 at relatively low prices. On the downside, the firm faces significant technological headwinds.
While deep value stocks are scarce, they can still be found and I fully expect the drought to be a temporary one. Sooner or later, the market will turn and offer investors a value feast, rather than a famine.