Universities are back in session and students are nervous about their prospects. I went to school in a Dickensian era when the saying, “Look left, look right, and one of you won’t be here next year,” was overly optimistic. My class shrank to a fifth its former size thanks to a semester of Newton followed by one of Einstein. I hope the situation is better today.
But, when it comes to investing, the idea of exchanging short-term pain for long-term gain hasn’t gone away. It represents the essence of value investing.
I’ll highlight the situation by starting with the 60 large stocks in the S&P/TSX 60 Index. The index chalked up average annual gains of 7.7 per cent from the end of January, 2002, through to the end of August, 2023. (The returns herein are based on monthly data from Bloomberg and include dividend reinvestment, but not fund fees, commissions or other trading costs.)
You can see the long-term returns of the S&P/TSX 60 in the accompanying graph, which also includes the returns of three concentrated value portfolios based on factors value investors love.
The first factor is the venerable price-to-earnings ratio (P/E), which compares a stock’s price to its earnings per share over the prior 12 months. The low-P/E portfolio invests equal-dollar amounts in the 10 stocks with the lowest ratios in the index. The stocks are held for a month, then replaced with a new batch of low-P/E stocks.
The low-P/E portfolio generated the best long-term returns of the three value portfolios with average annual gains of 10.8 per cent from the end of January, 2002, through to the end of August, 2023. It beat the index by an average of about 3.1 percentage points a year over the period.
The long-term returns are grand, but the portfolio got pummelled in the financial crisis of 2008-09. It gave up a staggering 70 per cent from its high in 2007 to its low in early 2009. The market held up better with a dip of 43 per cent from its high to low. While the portfolio’s collapse was at least partly attributable to the small number of stocks it holds, value stocks didn’t fare well in the crisis.
The portfolio’s second biggest decline was seen in the COVID-19-related crash of early 2020, when it tumbled 43 per cent from its former high while the index slipped 20 per cent.
Value investors also like to weigh up stocks based on their price-to-book-value ratios (P/B). This ratio compares a company’s market value to the amount of money that could be theoretically raised by selling off its assets (at their balance-sheet values) and paying off its debts.
The 10-stock low-P/B portfolio is running almost neck-and-neck with the low-P/E portfolio thanks to a surge after the bottom in 2020. The portfolio is now up by an average of 10.6 per cent annually from the end of January, 2002, through to the end of August, 2023.
The low-P/B portfolio had a hard time in the 2008-09 crash when it plunged 63 per cent. It also suffered from a decline of 53 per cent when the oil patch floundered in 2015 and the index dipped 13 per cent.
The third value portfolio tracks the 10 stocks with the highest dividend yields in the index, which are favoured by income investors. It fared a bit better than the index, with average annual gains of 8.4 per cent since January, 2002.
On the downside, the high-yield portfolio gave up 42 per cent from its high to low in the 2008-09 crash, and it declined 41 per cent in the 2015 dip.
Turning to the present, three stocks appear in all three value portfolios. They are Bank of Nova Scotia, Canadian Imperial Bank of Commerce and Manulife Financial. Together they have an average P/E of 9.2, an average P/B of 1.1 and an average dividend yield of 6.3 per cent. (By way of disclosure, I own a few shares of the three companies and several of the other stocks in the value portfolios.)
Much like obtaining a university degree, investors who choose to attend the value school might win over the long term, but they’ll probably suffer from a few hard knocks along the way.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
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