The first snow of the season blew through Toronto last week, and I’m already done with winter. Alas, it’s not done with me.
Investing also has its seasons, but they can last for years. Today I’m going to take a look at a successful but volatile value-investing approach and its hot and cold periods over more than two decades.
Most investors are familiar with the price-to-earnings ratio (P/E), which is an old measure of value. The enterprise-value-to-EBIT ratio (EV/EBIT) is a modern take on the P/E ratio. Looking at its components, enterprise value is – in simple terms – the market value of a company’s equity plus its net debt. EBIT is an abbreviation for earnings before interest and taxes.
Seeking stocks with low-EV/EBIT ratios tends to lead to cyclical firms that have posted unusually good results over the prior four quarters. That might be all fine and dandy when the firm is in an upward cycle, but it can be painful on the way down. However, the ratio has a good record of finding bargains over the long term.
The strength of the EV/EBIT ratio is illustrated by the Screaming Value portfolio, which starts with the largest 300 stocks on the TSX by market capitalization and then picks the 10 with the lowest ratios. The portfolio is rebalanced each month when an equal amount of money is invested in each stock. (The returns herein are based on monthly or annual data from Bloomberg. They include dividend reinvestment, but do not include inflation, taxes or trading frictions.)
The Screaming Value portfolio posted average annual returns of 13.3 per cent from the start of 2000 through to the end of October, 2022. By way of comparison, the S&P/TSX Composite Index trailed badly with average annual returns of 6.5 per cent over the same period. You can examine the portfolio’s growth, along with that of the market index, in the accompanying graph.
Big profits were also earned by value investors who rebalanced the portfolio once a year rather than once a month. The Screaming Value portfolio gained an average of 16.7 per cent annually from the start of 2000 through to the start of 2022 with annual rebalancing. The S&P/TSX Composite Index climbed by an average of 7 per cent annually over the same period.
But the second graph puts the screaming into the Screaming Value portfolio because it shows how far it fell in down periods. It also includes similar data for the market index.
For instance, the portfolio suffered from a shocking decline of 71 per cent from its high in the summer of 2007 to its low in early 2009. Such a decline would have prompted many investors to be just as done with the strategy as I am with winter.
The portfolio also lagged as interest rates climbed in 2018, and then the COVID-19 crash arrived to push it down 58 per cent by the end of March, 2020. It was a poor period for both the portfolio and value investing more generally.
The portfolio’s weak performance in hard times is partly attributable to its focus on just 10 stocks. A similar portfolio composed of the 20 stocks with the lowest EV/EBIT ratios fared a bit better in hard times, but it still gave up 65 per cent in the 2008 crash.
You can find the stocks that currently pass the Screaming Value test, along with updates to Frugal Dividend, Stable Dividend, and Dividend Monster portfolios below.
Despite its good long-term record, I admit to being hesitant when it comes to the portfolio’s near-term prospects, given its past behaviour in big crashes. I worry that a winter storm might be headed toward the market in the form of a recession – or worse. But I also like to keep track of the portfolio during downturns because its rebounds have been mindbogglingly strong.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.