Emily Halverson-Duncan: Value investing is a well-known and commonly used style of investing. The basic premise is to search for stocks, which appear to be undervalued. In other words, currently trading below what the buyer believes the stock is truly worth, otherwise known as its intrinsic value. When choosing a universe of stocks to explore for value in Canada, one of the most obvious choices is the S&P/TSX Composite. Today, I'm going to create a value strategy, which looks outside of that commonly used index and instead focuses on some of the lesser known Canadian names. So, let's take a look at how to construct that strategy.
So, first off, we're looking for stocks that have a lower price-to-forward earnings value, which is the ratio of their stocks price to its expected earnings. We're also looking for a lower five-year beta versus the S&P/TSX. Beta measures the sensitivity of a stock to the index, so having a lower sensitivity is considered a positive.
And then lastly, we're looking for a higher return on equity. In terms of screening, some of the screens we're applying here are a price-to-forward earnings in the bottom half of peers. So, bottom meaning that it's in a lower half of peers, which again with price-to-earnings is a positive. Beta less than or equal to 1, so as sensitive or less sensitive than the market. And lastly, trading volume, which is important screen here, where we're looking for it to be in roughly top of half of peers. So, reason for adding that screen is to get rid of any names that don't have as much liquidity, just to ensure you're able to get in and out of positions okay.
And then on the sell side, we really just have one major signal and that's again price-to-forward earnings. If it raises above a certain threshold, which is really the top or the highest price-to-earnings top third price-to-earnings, then we would sell it out of the model. But, of course, we want to see how that looks over time, so let’s go and run a back test. But before we run the back test, we're just going to go through our parameters. First off, we're running this strategy from December 1991 until end of February 2019. We're going to be running 15 stocks and then lastly, we're applying a 1% liquidity cost.
So, what liquidity cost is, is it adds 2.18 1 percentage or detracts 1% from the purchase or sale price of a stock to negatively impact that price. So, that you're taking into account any of the lesser liquid names that you might be holding. You're taking into account that potential negative impact you could have on the price. So, let's go ahead and see what that looks like. What we're looking at here is 15 stocks that were purchased in December 1991 and then we applied those buy and sell criteria that we looked at on a go-forward basis. Any stocks that hit that sell threshold would have been removed from the model and then replaced with the next highest ranked stock that we didn't already own.
Okay. So, the strategy actually did quite well. There's an annualized return of 17.8% and, again, that's net about of that 1% liquidity fee that we added in. And then that would beat the benchmark by 9.5% annualized, so a pretty wide margin. Turnover was only 44%, so it means that you were trading roughly less than half of your portfolio on an average year. A few other metrics to look at here, my favorite chart, this green and blue one, it looks at how your model did in both up and down markets. So, we can see this model outperformed in 56% of upmarkets, but more impressively outperformed in 78% of downmarkets. So, just very good downside protection, while still recouping a fair bit of the upmarket capture as well. So, overall we can see there's still value looking outside of the TSX in some of the less commonly known names in Canada.
For Morningstar, I'm Emily Halverson-Duncan.
