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A simple TSX stock-picking technique that would have produced 18.5% annual returns over the past 15 years

Applying simple value-investing strategies to the S&P/TSX 60 index produced wonders in recent years. It's high time to put them under the microscope.

The S&P/TSX 60 follows 60 of the largest enterprises in Canada. It includes big banks, insurance companies, utilities, resource firms and others. Over all, the index produced solid returns over the past 15 calendar years with average annual gains of 7.52 per cent, including reinvested dividends.

The S&P/TSX 60 holds each stock in proportion to its market capitalization (shares outstanding times share price) with an adjustment to reflect the number of shares available to investors. That is, shares tied up by strategic owners such as founders are excluded. But generally speaking, the index puts more money into larger stocks.

The approach makes it easy for index funds to track the index in a cost-effective manner because the funds don't have to trade much. The rare trades that do occur are often prompted by corporate actions, such as mergers, takeovers and the like.

But, when it comes to returns, investors might be better served by opting for an equally weighted portfolio. In this case, that would mean buying an equal dollar amount of the 60 stocks in the index and rebalancing the portfolio from time to time.

An equally weighted portfolio of the index's 60 stocks, rebalanced annually, gained an average of 9.35 per cent annually over the same 15-calendar-year period, according to Bloomberg's backtesting facility. It outperformed the index by 1.8 percentage points a year. But frictional costs, such as those from trading fees and taxes, would have dampened its relative attractiveness in practice.

Equal weighting generally favours smaller stocks in the index when compared with market-capitalization weighting. It also tilts more to value stocks that trade at low prices compared with their fundamentals.

But narrowing in on value stocks by using four simple strategies yielded even better results. Each strategy uses a different value ratio to select 10 stocks in the index that are held for a year and then the process is repeated.

If you had purchased an equal amount of the 10 stocks with the lowest price-to-book ratios from the 60 stocks in the index and held them for a year before refreshing the list, you'd have gained an average of 10.24 per cent annually over the 15 years through to the end of 2016. The strategy beat the index by an average of 2.7 percentage points annually. (Again, the results do not include frictions such as taxes, trading costs or fund fees.)

Picking 10 stocks with the lowest price-to-sales ratios each year fared even better. They climbed by an average of 14.42 per cent annually over the period and outperformed the index by an average of 6.9 percentage points annually.

The 10 stocks with the lowest price-to-cash-flow ratios did very well with average annual gains of 17.46 per cent. The portfolio outperformed the index by an average of 9.9 percentage points a year.

But the best returns were generated by moving into the 10 stocks with the lowest price-to-earnings ratios each year. The low-P/E method sported an average annual gain of 18.59 per cent and outperformed the index by a stunning 11.1 percentage points on average annually.

You can examine the current crop of low-P/E stocks in the accompanying table. (I personally own shares of many of them.)

But, before you dive in, it is important to be aware of a few caveats. The most recent 15-year period was an unusually good one for the low-P/E approach. It would have also required a great deal of fortitude to stick with the method through the crash of 2008.

In addition, 10-stock portfolios tend to be more volatile than diversified portfolios such as those offered by broad index funds. As a result, they are prone to both unusually good, and unusually bad, periods.

Over all, it seems likely that the relative merits of the low-P/E approach will moderate somewhat in the future. But it should lead investors some good bargains over the long term.

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

Low-P/E value stocks in the S&P/TSX 60

CompanyTickerRecent PriceP/EP/B
CenovusCVE-T$10.133.400.63
TeckTECK.B-T$28.328.020.89
Barrick GoldABX-T$21.108.582.09
MagnaMG-T$59.208.781.69
Husky EnergyHSE-T$14.459.570.88
CIBCCM-T$106.049.641.65
PowerPOW-T$29.9410.181.05
Thomson ReutersTRI-T$55.3111.172.57
Bank of MontrealBMO-T$90.8911.181.52
Sun Life Financial SLF-T$47.0111.191.39

S&P Capital IQ

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