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Why a stock screen is only a first step for bargain hunters

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

Every value investor has a favourite ratio. Some wax philosophical about the merits of price to earnings ratios, others extol the virtues of price to book value multiples, and a few opt for more exotic measures.

But the market tends to favour one ratio for a few years and then moves on to another. It's something money manager James O'Shaughnessy discovered when updating his book What Works on Wall Street.

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In early editions he pointed to stocks with low price to sales ratios (P/S) as having the best prospects. But, as time progressed, the ratio was eclipsed by other measures of value.

The fickle nature of the ratio race prompted Mr. O'Shaughnessy to, basically, throw in the towel. Instead of looking for the very best ratio he decided to use several to form a value composite, which he hopes will prove to be more consistent than the single ratio approach.

I employed a similar method to find interesting value candidates in the S&P/TSX Composite by using five measures of financial merit.

I started by looking for stocks with low price to earnings ratios (P/E) and low price to tangible book value ratios (P/TB) because value investors love to get lots of earnings and assets for a low price.

Dividend payments are also quite pleasing, which is why I added dividend yield (based on expected dividends over the next 12 months) to the mix.

The last two ratios are a little more unusual and both use enterprise value (EV) to measure price. Enterprise value represents the market value of a business, including both its equity and debt, while adjusting for cash. It's an estimate of what a private buyer might have to pay for a firm while settling its debts at the same time.

While stocks with low price to sales ratios can be attractive values, I opted for those with low enterprise value to sales ratios (EV/S) because they've performed better in the past.

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The fifth ratio is EV/EBITDA, which can be thought of as a variant of the P/E ratio. EBITDA stands for earnings before interest, taxes, depreciation and amortization, which is a rough measure of a firm's operational profitability that's independent of its capital structure.

Each factor was weighed equally to rank the 239 stocks in the S&P/TSX Composite Index based on data from S&P Capital IQ. Those with the best value characteristics (lowest ratios or highest yields) got the most points and the top 10 are displayed in the accompanying table.

Stock screens represent a good first step for investors. But each company should be examined in detail before diving in.

Take Reitmans (Canada) Ltd. (RET.A-T) as an example. The ladies' wear specialty apparel retailer, based in Montreal, ran into trouble over the last few years.

Its stock is down more than 50 per cent from its 52-week highs and it hit new lows this week. Regrettably, stocks with negative momentum have a nasty tendency of continuing to fall – at least in the short term.

Problem is, price weakness tends to go hand in hand with deteriorating fundamentals. In this case, Reitmans reported substantial year-over-year declines in sales, same store sales, and earnings last quarter.

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To compound matters, we're moving into tax loss selling season, which could prompt investors to sell their shares before the end of the year to lock in the tax benefit. It's an unwanted source of selling pressure.

If that weren't enough, dividend investors have to be concerned because the firm earned less over the last 12 months than it paid out in dividends. A dividend cut is a real possibility, and S&P Capital IQ estimates the dividend will fall to a quarterly rate of 5 cents per share next year from the current quarterly payout of 20 cents.

Even worse, the recent arrival of U.S. retailers in the Canadian market could make this holiday season an unusually difficult one.

Don't get me wrong, I hope Reitmans recovers. But bargain hunters might want to wait a bit before buying this one.

Globe app users can see the table here.

Value candidates from the S&P composite

Value stocks in the S&P/TSX composite

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