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It’s time to catch up on the value stock race. So far, the trend favours investors who keep an eye on debt while hunting for bargains.

I recently pitted 14 popular measures of value against each other in the U.S. market. Each measure was used to form a tracking portfolio containing the cheapest 10 per cent of the stocks in the S&P 500 index based on that measure. The 14 tracking portfolios were equally weighted and rebalanced annually.

For instance, value investors often favour stocks with low price-to-earnings ratios, or P/E. The 10 per cent of stocks in the S&P 500 with the lowest positive ratios gained an average of 9.5 per cent annually from the end of 1999 to the end of 2022. In comparison, the S&P 500 itself gained an average of 6.3 per cent annually over the same period. The low-P/E stocks beat the index by an average of 3.2 percentage points annually despite the many ups and downs along the way. (All of the returns herein come from Bloomberg. They include dividend reinvestment but not fund fees, taxes, commissions or other trading frictions.)

The accompanying table provides the average annual returns generated by the 14 portfolios based on different measures of value – including P/E. Note that each and every value portfolio outperformed the index over the period.

But that’s not to say the 14 value portfolios beat the index each and every year. Very broadly speaking, value fared well in the early 2000s as the internet bubble deflated, it struggled in the late 2010s and it offered more encouraging returns more recently.

Note that the table is split with the left side using ratios formed using price (or market capitalization when not calculating with per-share figures) in the numerator of each ratio while the right side shows ratios that use enterprise value instead.

Enterprise value, or EV, is often favoured by value aficionados because it incorporates debt into the picture. Simply put, it equals a firm’s market capitalization plus its net debt.

Investors were better off using the EV version of each ratio because they outperformed the corresponding price version by between 0.8 and 4.4 percentage points a year.

The table also includes returns for low price-to-dividend ratios, or P/D, which follows stocks with high dividend yields. In addition, the portfolio of low price-to-tangible-book-value ratio, or P/TB, stocks fared better than its more lenient brother using low price-to-book-value ratios, or P/B.

If you’re like me, your eye is probably drawn to the gains of the portfolio tracking stocks with low enterprise-value to free-cash-flow ratios, or EV/FCF, because it won the performance race. The portfolio gained an average of 14.9 per cent annually from the end of 1999 to the end of 2022. The low-EV/FCF portfolio currently holds 41 stocks in the S&P 500 with positive EVs and FCFs.

(Free cash flow is theoretically the amount of money a company can distribute to its shareholders without affecting its operations. In this case it is approximated by subtracting capital expenditures from cash flow from operations.)

Throwing caution to the wind, I decided to take a more concentrated approach to build the cheekily named Free Cash portfolio. It holds the 10 stocks with the lowest EV/FCFs in the S&P 500 and opts for monthly updating.

The Free Cash portfolio’s performance history can be examined in the accompanying graph. It gained an eye-popping 20.5 per cent on average annually from the end of 1999 through to the end of February, 2023. The S&P 500 gained an average of 6.4 per cent annually over the same period. (The 10-stock portfolio gained an average of 14.9 per cent annually when rebalanced annually instead of monthly.)

Alas, the Free Cash portfolio didn’t actually provide cash free. Instead, it came at the cost of a huge amount of volatility and associated heartburn. The portfolio was approximately 50 per cent more volatile than the S&P 500 over the past 23 years and two months, which isn’t great. It was also almost three times as volatile as my Stable Dividend portfolio, which follows large Canadian blue-chip stocks such as banks, telcoms and utilities.

Stated alternately, the Free Cash portfolio suffered from monthly losses of more than 20 per cent on four occasions since the start of 2000 and monthly losses of more than 10 per cent a full 16 times. Gulp.

I hasten to add that I expect the Free Cash portfolio’s returns to moderate in the future. After all, there is a long history of a “hot” ratio providing blowout returns for a time only to see a different ratio go on to win the race in the future. I have no reason to believe that EV/FCF will be the exception. But I hope it fares reasonably well, like the other measures of value, over the long term.

You can examine the stocks in the Free Cash portfolio via this link, which also provides updates for the other portfolios I track for the Globe.

Norman Rothery, PhD, CFA, is the founder of

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