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A slice and dice investing strategy

Traders must remain flexible and alert to change because, as recent events prove, no one can perfectly forecast what’s going to happen.

Last week, our American cousins celebrated Thanksgiving. A great many turkeys were sliced up for the occasion and each gobbler consumed their favourite bit.

Similarly, stock pickers slice up the market and invest in companies they expect to provide the most succulent returns.

The best way to chop up the market is naturally the subject of some debate. But it is useful to start by considering factors that have led to strong returns in the past. Money manager James O'Shaughnessy wrote the book on the topic. The latest edition of his What Works on Wall Street examines a slew of factors from ratios value investors love to return patterns followed by momentum investors.

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For instance, he found that a portfolio composed of the 10 per cent of large U.S. stocks with the lowest price-to-earnings ratios, rebalanced annually, outperformed the market by an average of 3.4 percentage points a year from 1964 to the end of 2009. Stocks with higher ratios fared less well. The 10 per cent of stocks with the highest ratios underperformed the market by an average of 3.6 percentage points annually over the same period.

That's all well and good, but most investors consider more than one factor when looking at stocks to buy. However, there is a tension between selectivity and diversification when it comes to smaller markets.

The issue becomes evident when implementing a two-factor method in Canada. It starts with the low price-to-earnings ratio test and then picks stocks that have high total returns over the prior 12 months. Think of it as a value-plus-momentum strategy.

In the United States, both methods have worked well on their own and the combination has worked even better.

This works in the U.S. stock market because it is very large. It contains 2,353 stocks with both market capitalizations and annual revenue in excess of $250-million. On the other hand, there are only 283 such firms in Canada, according to data from S&P Capital IQ.

Take out the carving knife and you'll run out of Canadian names quickly when slicing twice. If you pick the tenth of stocks with the lowest positive price-to-earnings ratios in the United States, you'll be left with 181 stocks whereas there are only 19 in Canada. Now pick the tenth of the stocks from the low-P/E groups with the highest returns over the past year and you are left with 18 names in the United States and two in Canada.

While 18 stocks might be sufficient for a focused U.S. portfolio, the two-stock Canadian portfolio is far too concentrated. Simple factor-based approaches like this one rely on an adequate amount of diversification to reduce stock-specific risk and a two-stock portfolio is far too risky in this regard.

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But, for those interested in adding stocks to an already reasonably diversified portfolio, the two Canadian stocks that passed the value-plus-momentum test this week are Air Canada (AC) and Paramount Resources Ltd. (POU).

Air Canada is based in Saint-Laurent, Que. and should be familiar to air travellers. Its stock trades at 4.2 times earnings and has climbed 36 per cent over the past 12 months.

Paramount is an oil and gas business based in Calgary that owns a stake in several other energy-related firms. Its stock trades at 5.2 times earnings and has gained 92 per cent over the past year.

To get around the small number problem, Canadian investors can diversify geographically by also buying U.S. and international stocks. They can also loosen their requirements while lowering their return expectations somewhat.

Alternately, they can follow a collection of multifactor strategies that have done well in the past. In addition to low-P/E high-momentum stocks, they might also buy stocks with low price-to-sales ratios and high momentum and stocks from similar strategies.

While our neighbours are gobbling down stocks in the large U.S. market, it is important to remember that the pickings are slimmer north of the border and plan accordingly.

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About the Author

Norman Rothery, Ph.D., CFA, is the founder of StingyInvestor.com and has been catering to value investors since 1995. He publishes the Rothery Report, a value stock newsletter. Norm obtained a Ph.D. in atomic physics from York University before following his passion for investing. More

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