Next time you're in the bathtub, consider the dynamics of the rubber duck – an easy-to-submerge toy that quickly pops to the surface when it is released.
In much the same way, value investors buy stocks that the market has pushed deep underwater because they expect these firms to turn around and head back to more normal levels.
The problem is that rubber ducks are much more reliable . Some stocks sink to the bottom and stay there. Nonetheless, most companies that suffer from periods of poor performance go on to rehabilitate themselves. That's why buying stocks when they are underwater – at least in terms of their usual valuations – can be a good investing strategy.
To make this work, though, you have to know what you're buying – and what a return to normalcy might look like. That's why I like to track how a stock's price-to-book-value (P/B) multiple has developed over time.
Book value provides a gauge of how much a firm's assets exceed its liabilities (although there are numerous accounting technicalities that make it only a rough estimate). Past patterns in the P/B ratio provide an indication of how much the market is willing to pay for a company both in good times and bad.
Take National Bank of Canada. It hit a P/B high of 2.59 in 2006 and a low of 0.86 in 2008 according to S&P Capital IQ. Recently, the bank's P/B came in at 1.9, which is just a touch above the middle of its historical range since the start of 2006.
A particularly optimistic investor might hope for the bank to move back to its old highs while a bargain hunter might be keen for a return to the depths of 2008.
Whichever way you lean, a look at past P/B ratios allows you to put reasonable limits on your hopes. Based on its recent book value of $41.02 a share, the optimist can dream of prices near $106 a share (2.59 times $41.02) while the bargain hunter would prefer prices near $35 a share (0.86 times $41.02).
This is not an exact science. Picking off a stock at its extreme low then selling at its extreme high would be grand but a stock rarely retraces its history that exactly. Instead, it's sensible to look to more moderate multiples. For instance, you might consider a buy when a stock trades in the lower 20 per cent of its P/B range. Or exiting if it's in the upper 80 per cent of the range.
Such levels are, of course, a matter of preference. You might decide that 25 per cent and 75 per cent are better. The very thrifty might buy near the lows and then look to sell when a stock returns to the middle of its P/B range.
Let's look at how all of the large stocks in the S&P/TSX60 index stack up. The table shows the 60 stocks in the index, along with their current P/B ratios, and where the ratios fall in the firms' high-low P/B range since the start of 2006. A firm trading at 0 per cent is at its lowest P/B ratio since 2006; a firm trading at 100 per cent is at its highest.
To help those who want to save their pennies, the table is ordered by P/B range. Stocks with low ratios compared to their historical levels are shown at the top of the table and high multiple stocks are at the bottom. (Only the top 20 stocks are shown in print; the remainder are available online.)
You'll notice that some of the stocks near the top of the table don't have low P/B ratios in an absolute sense. They're only low in comparison to their past histories. As a result, value investors might skip over these firms and stick to stocks with low ratios over all and low ratios compared to their own history.
Just keep in mind that, unlike the physics behind rubber ducks, multiple analysis isn't a precise science. It is best to use it to get a sense of where a stock has been.