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A value strategy seeking the most succulent returns

Thanksgiving dinner should come with a warning label. Something like, the turkey and gravy may induce belt loosening and mild catatonia. Complications may occur when taken with an extra slice of pumpkin pie.

Complications can also bedevil stock pickers when it comes to back-testing their favourite strategies. It's easy to find a hyperspecific method that has worked well in the past only to see it fail in practice. To avoid this fate, it is important to loosen up a strategy's parameters to see how it reacts to change.

That's one reason I decided to apply the four classic value investing strategies I examined a few weeks ago to the S&P/TSX composite rather than the S&P/TSX 60. The former tracks 251 of the largest stocks in Canada today and is broadly representative of the easily investable part of the market. It includes the 60 giant stocks in the S&P/TSX 60 along with 191 smaller names. (The number of stocks in the S&P/TSX composite changes slightly from year to year and its predecessor index, the TSX 300, tracked 300 stocks.)

Return-wise, the S&P/TSX composite fared well over the 15 years through to the end of 2016 with average annual gains of 7.41 per cent. Alternately, those who bought an equal dollar amount of each stock in the index and rebalanced annually saw average annual gains of 7.45 per cent. (The returns herein represent compound annual returns and do not include frictions such as index fund fees, trading costs, or taxes.)

The four value strategies use different ratios to slice up the market into portfolios that are rebalanced each year. But rather than picking the top 10 stocks, as was done last time for the S&P/TSX 60, the top 20 names are selected from the much larger S&P/TSX composite.

The value strategy that supplied the smallest advantage focused on book values (a measure of corporate net worth). If you had purchased an equal amount of the 20 stocks with the lowest price-to-book-value ratios (P/B) in the S&P/TSX composite and held them for a year before refreshing the list, you'd have gained an average of 7.84 per cent annually over the 15 years through to the end of 2016.

While the low-P/B strategy beat the index by an average of 0.4 of a percentage point per year, such a slim advantage might be overwhelmed by trading frictions in practice. (Low-P/B stocks also provided the smallest boost in the S&P/TSX 60.)

Picking the 20 stocks with the lowest price-to-sales ratios in the S&P/TSX composite each year yielded better results. The group climbed by an average of 12.48 per cent annually over the 15-year period and outperformed the index by an average of 5.1 percentage points annually.

The 20 stocks with the lowest price-to-earnings ratios (P/E) also fared well with annual returns of 13.06 per cent over the period. They outperformed the index by an average of 5.6 percentage points (due to rounding) a year. But they didn't fare nearly as well as the 10 low-P/E stocks from the S&P/TSX 60, which climbed by an average of 18.59 per cent annually. The lower returns seen here, while still generous, may be more representative of the low-P/E method's long-term potential.

The most succulent returns were generated by the 20 stocks with the lowest price-to-cash-flow ratios. They gained an average of 16.44 per cent annually and outperformed the index by an average of nine percentage points per year. You can examine the current list of low price-to-cash-flow candidates in the accompanying table. (I happen to own some of these stocks.)

Moving from the 60 stocks of the S&P/TSX 60 to the 251 stocks of the S&P/TSX composite, and going from 10 to 20 value picks, generally reduced the return advantage provided by the value strategies. But they still outperformed the index and the gains were sizable for the methods based on sales, earnings and cash flow ratios. With a bit of luck, they'll continue to provide a feast of returns to investors.

Stocks with low price-to-cash-flow ratios in the S&P/TSX composite index

CompanySymbolRecent priceP/CFP/EP/SP/B
Home Capital GroupHCG-T$13.950.3514.253.110.65
Valeant PharmaceuticalsVRX-T$17.921.56n/a0.541.27
Power CorpPOW-T$31.912.4010.850.301.12
Manulife FinancialMFC-T$25.342.7813.851.261.26
Laurentian Bank of CanadaLB-T$59.903.7213.402.531.20
Fairfax FinancialFFH-T$646.003.91n/a1.461.37
Power FinancialPWF-T$35.183.9611.530.521.44
Teck ResourcesTECK.B-T$27.734.497.861.400.87
Brookfield Property PartnersBPY.UN-T$29.574.8314.570.850.83
Great-West LifecoGWO-T$35.766.1314.020.781.79
Hudbay MineralsHBM-T$9.716.35194.201.691.03
The Stars GroupTSGI-T$25.356.5321.132.491.91
Western Forest ProductsWEF-T$2.627.1410.920.871.90
George WestonWN-T$110.007.3323.610.292.03
Genworth MI CanadaMIC-T$37.587.856.993.710.90

Source: S&P Capital IQ

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