What are we looking for?
Whether adding a stop-loss order will have a positive impact on a value strategy.
In theory, investing is simple. Create a plan, implement it, then sit back and relax.
In practice, however, investing is much more difficult. While you may be initially comfortable with the portfolio you have in place, once one or more holdings begins to lose money, that level of comfort can begin to erode. Should you cut your losses and sell the falling securities, in the hopes to avoid further declines?
This issue can be especially prevalent for value investors. Recall that value stocks are those that are currently trading for less than what you believe they are worth. Of course, after you buy them, stocks can decline still further before beginning to climb to a higher price point, or they may never reach that expected value at all – the classic “value trap.”
One systematic way to limit your loss is to implement a stop-loss order, whereby your broker sells the stock when it hits a certain price threshold.
Today, I’m comparing a Canadian value model to the same model, but with a 30-day stop-loss order of 15 per cent applied: If a stock’s price has fallen 15 per cent or more over the past 30 days, the stock in the stop-loss model is sold.
In order to qualify for the value model, the stocks must have a:
- Price to trailing earnings (measured as the company’s most recent share price divided by the previous four quarters’ earnings per share; low values are preferred) in the bottom half of all Canadian stocks – that value today is 17.6 or below;
- Price to book value (measured as the company’s most recent share price dividend by the book value per share; low values are preferred) in the bottom half off all Canadian stocks – that value today is 1.4 or below;
- Price to trailing cash flow (measured as the company’s most recent share price dividend by the most recent four quarters of operating cash flow; low values are preferred) in the bottom half of all Canadian stocks – that value today is eight or below;
- Market cap greater than $150-million;
- Payout ratio (calculated as dividends per share divided by earnings per share) less than 80 per cent to ensure earnings were not all being paid out as dividends.
We also included the 30-day price change to indicate which stock or stocks would be sold in the stop-loss model because they broke the 15-per-cent threshold.
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 120 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to back-test these strategies from May, 2002, to November, 2019. During this process, a maximum of 10 stocks were purchased. Stocks were sold if the company’s payout ratio rose above 80 per cent, or in the case of the stock-loss model, only if a stock price fell 15 per cent or more in the previous 30 days (which today would mean Semafo Inc., our No. 1 ranked value stock, would be jettisoned). When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Over this period, the original strategy produced an annualized total return of 12.2 per cent while the stop-loss version produced a return of 11.3 per cent. The S&P/TSX Composite Index registered an annual gain of 7.5 per cent on a total return basis over the same period. It’s also worth noting that both models outperformed in 70 per cent of down markets compared with the S&P/TSX.
In this scenario, selling stocks based on a declining price did not prove to be advantageous from a return perspective.
Stocks that qualify for purchase into the strategy today are listed in the accompanying table. As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed below.
Emily Halverson-Duncan, CFA, is a director, CPMS sales at Morningstar Research Inc.
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