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Money for nothing

When you find a dollar on the sidewalk, do you pick it up? I bet you do. After all, free money doesn't come along every day. What you may not know is that the stock market also offers up cheap money from time to time. You just have to learn how to spot it.

One way to find this cheap money is to take a close look at corporate balance sheets. These financial statements, tucked away in companies' annual reports, are ignored by many investors, but they provide a road map to hidden value.

When looking at balance sheets, I'm most interested in what is known as book value, or shareholder equity. This is equal to a company's assets minus its liabilities. An accurately reported book value provides a good estimate of the minimum value of a company. Provided that the firm earns more than inflation, you should always be confident that a company is worth at least its book value.

What does this mean for those of us looking for cheap stocks? In theory, you should be able to do quite well by waiting for the market to become overly pessimistic about a solid firm, then buying shares in that company when the stock price drops below the book value.

Unlike many investing theories that flunk the test of the real world, this strategy of buying low price-to-book stocks has actually proven to be quite profitable in practice. In his landmark 1998 book, What Works on Wall Street, the money manager and investment researcher James O'Shaughnessy found that the U.S. stocks with the lowest 20% of price-to-book-values beat the market by an average of over 2% annually from 1951 to 1996. Even better results were seen by the famous value investor David Dreman in his study of U.S. stocks covering 1970 to 1996, and by the renowned academic duo of Eugene Fama and Kenneth French in their seminal research on stock prices from 1927 to 2003.

Inspired by these results, I decided to conduct my own search for Canadian stocks with low price-to-book-values and solid potential. I started with the 223 large stocks in the S&P/TSX Composite. As a first step, I narrowed those couple of hundred stocks down to the 22 with price-to-book-value ratios of less than one. By the standards of today's stock market, when it's common for firms to trade at two or more times their book values, these stocks were undeniably cheap.

But that wasn't enough. I also wanted any potential investment of mine to be a fundamentally sound business. Hence, I subjected each of the 22 lowprice-to-book stocks to a further test by examining its earnings yield in other words, how much it earned per share, compared to its share price. Since inflation is running at roughly 2.5% a year, I wanted to look only at stocks that could at least keep pace with inflation, meaning an earnings yield of more than 2.5%. Only 13 of the 22 stocks on my initial list made the cut.

Next, I searched for some assurance that this baker's dozen of remaining stocks would continue to be profitable. This was the most difficult part of my research, because predicting the future is a highly subjective exercise. Bay Street analysts, for instance, have an annoying habit of being positive about nearly every stock they come across. Rather than relying upon their optimistic evaluations, I decided to use dividends as an imperfect signal of future profits.

My reasoning was simple. Managers usually try to set dividends lower than what they think their firm can earn. They do this because CEOs and other senior executives want to avoid the embarrassment of being forced to cut their firm's dividend. Consequently, any company that pays dividends tends to be one in which management is optimistic about the long-term profitability of its business. On the other hand, companies that don't pay dividends may be unsure about their future profits. Removing these non-dividend firms reduced my list to seven super stocks, which I've listed.

The first super stock is the 334-year old Hudson's Bay Co. It recently attracted the attention of South Carolina financier Jerry Zucker, who is now its largest shareholder. Furthermore, Target Corp is rumored to be making a bid for the firm. Although both Target and the Bay have discounted the idea, a future merger may be a possibility.

Fairfax Financial occupies the No. 2 position on my list. A personal holding of mine, Fairfax is primarily involved in property and casualty insurance. The company has attracted a great deal of ugly press over the last year, driven by short sellers who question the quality of Fairfax's assets and liabilities. Take my word for it the controversy is complex and involves questions of how to account for future obligations. But that type of dispute is typical of what you can expect to encounter if you hold unpopular value stocks. Such stocks are usually unpopular for a reason. You should do further research and come to your own conclusions rather than merely buying because of a low price-to-book ratio.

Given the stress and volatility involved, I recommend you explore the low price-to-book bargain basement only if you're adventurous. There are no guarantees. Sometimes low price-to-book stocks go on sinking. Still, there is lots of opportunity here if you're prepared to do the research and endure the downturns. History indicates that the profits from a diversified selection of value stocks more than make up for a few duds.



Super Stocks

An excellent way to find undervalued stocks is to look for solid businesses trading below their book values. Each of the firms listed here is both cheap and profitable — a potential winning combination.

 Company   Price   P/B   P/E   Dividend 
 Yield 
 Hudson's Bay (HBC)   $15.00   0.41   14.6   2.4% 
 Fairfax Financial (FFH)   $189.74   0.68   27.0   1.0% 
 CP Ships (TEU)   $16.69   0.89   9.9   1.3% 
 Intrawest (ITW)   $19.69  0.92   17.0   0.8% 
 IPSCO (IPS)   $30.38   0.94   10.7   0.7% 
 Laurentian Bank (LB)   $27.63   0.94   8.7   4.2% 
 Sears Canada (SCC)   $16.35   0.95   13.0   1.5% 
Source: tsx.com, globeinvestor.com, www.standardandpoors.com, as of Aug. 14, 2004


From the Sep 2004 issue.

Please note that I don't pick the titles for my MoneySense articles and I don't much care for the 'Money for Nothing' title.

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