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A sector-by-sector approach to finding value stocks

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

A warm spell dashed the hopes of ice fishermen in Southern Ontario this week because ice covered less than 12 per cent of the Great Lakes according to the U.S. National Oceanic and Atmospheric Administration.

But casting a line from shore, or visiting a favourite fishing hole, might be possible.

When it comes to fishing for stocks, value investors are skating on thin ice because the bargains they desire are disappearing as the markets warm. To find the few bargains that remain it is useful to take a step back, consider the market as a whole, and drill down into different sectors.

Today I'll define the market as stocks that trade on the Toronto Stock Exchange with market capitalizations in excess of $100-million. The smaller fry are excluded because they can be risky and deserve extra care. That leaves 559 stocks to choose from according to data from S&P Capital IQ.

It might surprise you to learn that only 53 per cent of the 559 firms sport positive trailing earnings (over the last four quarters). A mere 28 per cent trade at price-to-earnings ratios of less than 20, which is the level deemed by many value investors to be the most they'd pay for a stock. Some 19 per cent trade at less than 15 times trailing earnings, a more traditional value cutoff for higher quality businesses. The bargain bin, with stocks that trade at less than 10 times earnings, represents just 7 per cent of the market.

If you break the market down into sectors, you'll see where earnings are plentiful and where they are scarce. Three sectors are outliers at the moment because less than a third of their members managed to earn a profit over the last year.

The worst sector might come as a surprise. A mere 18 per cent of the stocks in the Canadian heath care sector earned more than a nickel over the last year. Matters are better in the hard hit energy sector where 22 per cent of firms have positive earnings and the fraction rises to 33 per cent in the materials sector.

In comparison, more than two thirds of stocks in the other sectors are profitable. You can examine the figures in the accompanying table.

Value investors will note that the sectors with the largest fraction of stocks in the bargain bin (trading at less than 10 times trailing earnings) are: real estate, financials, utilities, industrials, and consumer discretionary.

But focusing on trailing earnings alone is somewhat akin to using the rear-view mirror while driving. It can lead to accidents.

The sector ranking changes when forward price-to-earnings ratios are considered instead of trailing ratios. That is, when using a company's expected earnings for the next four quarters based on forecasts from industry analysts.

Forward price-to-earnings ratios point to the consumer discretionary, financials, materials, industrial, and information technology sectors as having the highest percentage of bargains.

Dive into the financial sector and you'll find 31 stocks trading at less than 15 times trailing earnings and 9 at less than 10 times earnings.

If you focus in on stocks trading at less than 10 times forward and 10 times trailing earnings, you'll find four names that happen to be linked to the mortgage business. They are: Genworth MI Canada (MIC), Home Capital (HCG), Equitable Group (EQB), and MCAN Mortgage (MKP). Owning them requires a non-calamitous view of the housing market.

Those with calamitous views might consider E-L Financial (ELF), an insurance-based conglomerate, instead. It trades at less than seven times earnings and lacks a forward P/E ratio due to a paucity of analyst coverage. (I've owned the company's shares for years.) The firm also trades at a sharp discount to its net asset value. It's worth a second look in a market where the number value stocks is thinning due to market warming.

The fraction of Canadian stocks by sector and P/E ratio

SectorProfitableP/E less than 20P/E less than 15P/E less than 10
Consumer Discretionary75%38%23%7%
Consumer Staples69%27%12%0%
Energy22%5%3%3%
Financials74%63%50%15%
Health care18%0%0%0%
Industrials72%35%26%9%
Information Technology73%23%10%0%
Materials33%15%9%3%
Real Estate83%63%44%19%
Telecommunication Services100%50%0%0%
Utilities67%24%19%14%

Source: S&P Capital IQ. Data as of Jan. 19

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