It can be difficult to identify the best value stocks in Canada. The truth is that today’s definition of an excellent value stock is less clear than it was when value stock pioneer Ben Graham wrote his classic work on investing.

In our series on Million Dollar Journey fundamentals, this is the second article. With our fundamentals series, we hope to simplify some challenging subjects for you so you can move forward with confidence when making investment portfolio decisions.

Before, we talked about what stocks are, how to buy and sell them in Canada, and why you should be concerned. Following that article, a number of readers wrote in with inquiries like: “What methods should I employ to

WHAT IS VALUE INVESTING?

There are various ways to characterize value investment. Still, I shall strive to do so with a simple statement (followed by a more thorough explanation) (followed by a more substantive explanation).

In the simplest sense, value investing is buying in stocks that are at a discount.
You acquire stocks when they are valued less than they should be.
That’s it.

You go to the stock store, hunt for the beat-up soup cans of the world of the stock, and then buy them at a big discount.

So go fire up your internet broker account and get rich.

But… it turns out that it’s a bit harder than gazing at a soup can when it comes to judging if a stock warrants its discount.

To better demonstrate this notion, imagine the following scenario:

• Consider that your favorite tub of ice cream, let’s say rocky road, costs around $7 at the neighborhood market.
• Imagine being able to break down the cost of this container of ice cream into all of its components, including how it was produced and delivered to you. Include in this: the price of the cream, sugar, chocolate, and all the other materials; the cost of the labor and packaging; and the cost of delivery.
• Let’s say the whole cost of the ice cream, including all of its ingredients, is roughly $6.50.
• This means that the maximum profit (also known as the markup) that the ice cream manufacturer and grocery shop can make is only $0.50.
• Let’s further assume that the producer and the retailer each receive $0.50 in equal amounts. Let’s also suppose that this profit is reasonable, enabling the producer and the grocery to support themselves and their operations.

You might be thinking, “Hey, that ice cream costs $6.50 to make from scratch, and I’m just paying a $0.50 premium to the ice cream manufacturer and the supermarket.” It even appears fair, which is not awful. Let’s refer to this situation as “fair value,” meaning that you are paying a reasonable price for the ice cream (and it is wonderful).

Let’s imagine that the summer is in its middle. The identical ice cream costs $10.

You are aware that making the ice cream only costs $6.50. Given that the producer normally keeps their markup/profit constant (let’s assume it stays at $0.25), the supermarket store has increased the price by $3.25. This ice cream is now obviously pricey, however some individuals could still choose to purchase it. We’ll refer to this situation as “overvalued” as you are actually paying nearly a 50% premium over the cost of the ice cream.

Let’s conclude by imagining that it is the midst of winter. Ice cream is overstocked at the supermarket, and it is now offered at a sale price of $6.80.

Let’s continue to assume that the producer’s markup/profit (again, $0.25) hasn’t changed. This means that the grocery only makes $0.05 for each tub of ice cream that is sold. They obviously don’t care about making a profit in this situation and are really motivated to sell the ice cream. So you make the obvious and wise decision to purchase 2 or 3 tubs. Hence, this situation is referred to be “undervalued.” You are paying very little more than the cost of the ice cream and less than what is reasonable because it is likely that the grocery store is not making enough money to stay in business.

Even better would be if the flavor of the ice cream suddenly changed. This particular flavor of ice cream was no longer in vogue. In this case, the grocery store continues to lose money as it occupies prime retail space, which makes it less and less popular. In this case, you may buy a lot of your favorite delicacies for less money than it costs to make them!

How does the aforementioned example apply to value investing?

You are giving yourself what Benjamin Graham, the pioneer of value investing, refers to as a “margin of safety” by making an investment in a firm that is undervalued. Because you’re probably paying less than the sum of the company’s parts, a margin of safety provides protection and security against negative market consequences (such as a bear market).

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The Quick History Of Value Investing

This individual, Benjamin Graham, is credited with coining the phrase and popularizing the value investing approach. Several of the most famous and successful investors known and alive today were influenced by Graham’s work and career as a teacher at Columbia. Irving Kahn, Charles Brandes, and famed investor Warren Buffet are among his students. In fact, Warren claimed that his own father’s influence over him was only surpassed by Graham’s.

Graham outlined guidelines and “tests” that can help you determine if a specific company is overvalued or undervalued in his magnum opus, “The Intelligent Investor.” These principles continue to be extensively applied today as the foundation for valuing businesses because they have continually stood the test of time.

In Graham’s book, there are many rules, but in this post, we’ll concentrate on a few basic rules that anyone can apply, what they signify, and where to locate the data.

WHY AND HOW DOES VALUE INVESTING WORK?

We need really become familiar with the idea of “Efficient Market Theory,” or EMT, before choosing the best value stocks in Canada.

All stock selection techniques eventually have to compare themselves against EMT, including the never-ending debate between growth and value equities.

Efficient Market Theory

In a nutshell, the market is effective, be it the stock market, a farmer’s market, or a grocery store. Items are priced relative to one another, and given all the information available to sellers and buyers, prices will rise or fall based on how much value consumers assign to the item in relation to its cost.

Why do I say that? Let’s return to the ice cream scenario from earlier.

Imagine that a tub of ice cream at Supermarket A costs $10 too much. Other individuals will buy it because they simply value the ice cream and don’t want to compare prices or give it any thought.

Customers will probably quit purchasing the pricey ice cream as word spreads that every other store, including Supermarket B, sells it for far less. The store will then return the pricing to normal since it doesn’t want to be left with a huge ice cream stockpile. Here is an illustration of how an effective market forces an inflated ice cream pricing down to normal. The same phenomenon occurs in the stock market as well.

Let’s say Supermarket B sells ice cream for $6 less than it should. This supermarket is doing this voluntarily because they simply want to get rid of the ice cream before it approaches its expiration date and are not advertising it. This ice cream begins to sell.

Many of it.

Then they inform their family and friends.

Soon enough, news spreads and people begin swarming to the store to get this ice cream as well. Well, the supermarket (if they were wise) would probably take this as an opportunity and boost the price of the ice cream back to normal. They are able to do this because they didn’t promote or guarantee anyone that it would be at that price for a specific amount of time.

Now, some individuals might say, “Forget about it,” and stop purchasing the ice cream, but the majority will. Because it was in the supermarket’s best interest, the market ultimately compelled the store to raise the price. Here is an illustration of how an effective market returns an undervalued good like ice cream to its usual price. In the stock market, the same thing keeps happening.

Efficient Market Theory And Margin Of Safety

Having said that, let’s connect efficient markets and margin of safety and examine this in the context of two key scenarios.

1) When there is a declining trend in the stock market (a bear market)

2) Whenever the stock market is trending up (a bull market).

In a bear market (a market that is heading downward), overvalued corporations often experience a considerably greater decline in market value than companies that are fairly valued.

However, undervalued businesses often don’t alter all that much in a downturn and, in certain situations, might even increase in value. This occurs when a company’s financial information, including its current and potential for financial success, is available to the general public. It doesn’t take long for the word to go out that a business is “on-sale” compared to its true value (i.e., the profits it can make now and in the future). Soon, many people will be vying for ownership of that business.

Purchasing stock in a company at a discount makes sound financial sense when the market is in a bull market (upward trend). The market is moving upward, and investors are all in a purchasing mood, which drives up the cost and value of reliable, trustworthy businesses. Imagine finding a business that was not only fundamentally sound (strong financials, a top-notch product, and a bright future for profits), but also for a great price?

You’re merely compounding your potential return, then. You are purchasing an additional supply of chocolate chip ice cream at a price you consider to be reduced in exchange for a stream of earnings that will continue in the future.

In conclusion, by making an investment in a firm that is undervalued, you guard against losses during difficult times and position yourself for a solid, healthy return during prosperous times.

VALUE INVESTING IN MUTUAL FUNDS AND INDEXES IN CANADA

Now that we know what value investing is and why it’s a good idea to invest in cheap firms, how should we put this knowledge to use?

You already know that we at Million Dollar Journey highly advocate index stocks and mutual funds from prior articles like Indexed Family Education Fund, Index Investing for Expats, and Creating a Simple Low-Cost Indexed ETF. In fact, for the majority of investors, our suggested strategy is value investing in mutual funds and ETFs (Exchange Traded Funds). They’re a terrific way to routinely diversify and balance your stock portfolio in addition to being an inexpensive and simple way to buy stocks.

In light of the foregoing, the following is a short list of mutual funds and ETFs that use the value investing methodology:

One of the biggest and most popular ETFs for most investors is the Vanguard Value ETF. The exposure to large-capitalization value equities is fantastic, and the cost is extremely cheap at just 0.04% as of this writing.

Vanguard Small-Cap Value ETF – This ETF is for you if you’re seeking for small/mid-cap (i.e., businesses that aren’t the biggest in the US and have their own benefits and drawbacks) investments. Its pricing is cheap, though not quite as low as the Value ETF above, like its big brother. The management fee is only 0.07% as of this writing.

Go no farther than BlackRock’s ETF for exposure to emerging markets, which includes developing nations and economies including China, India, Mexico, etc. One of the variations is less expensive than their flagship Emerging Markets ETF (the iShares MSCI Emerging Markets ETF, ticket EEM). This ETF costs 0.11%, which is significantly less expensive than EEM’s 0.70% fee, which is seven times as expensive.

As you can see, there are several ways to gain quick and inexpensive exposure to a diverse range of Canadian value stocks.

HOW TO INVEST IN VALUE STOCKS IN CANADA

It will be necessary to select your candidates among a range of sectors after narrowing the field to find the top Canadian value stocks for your particular portfolio. It has many similarities to our investing method known as the Dogs of the TSX.

The two most fundamental metrics we employ to identify value stocks are:

• Price-to-Earnings Ratio
• Price-to-Book Value

When investing, these two guidelines can assist you in determining whether a firm is undervalued and offers a good margin of safety. These guidelines are pretty easy to comprehend, calculate, and have a big potential for weeding out overvalued enterprises.

Nevertheless, Graham also discusses other principles in “The Intelligent Investor” that support these principles. If you’re interested in learning more about these principles, we suggest reading the book.

Rule #1 – Price To Earnings Ratio

Searching for a relatively low P/E ratio is the first criterion to follow when trying to separate Canadian value stocks from the vast universe of all Canadian publicly traded companies. The letters P and E, respectively, stand for price and earnings. Investors can determine the current price of the company in relation to its most recent profits (also known as earnings) using this fraction (or ratio).

A stock is deemed a value stock if its current price is less than fifteen times the company’s average earnings (per share) over the previous three years.
Alternatively stated:

According to most definitions of the word, a stock is deemed a value stock if its three (3) year average P/E (price to earnings ratio) is less than or equal to fifteen (15).
Let’s dissect and comprehend the fundamental parts of the rule in order to comprehend what we mean.

Current Price Stock: This is the current price of the stock, and it is a simple question. If you were to buy the shares, you would pay this amount.

Earnings, often known as earnings per share (EPS), is a company’s net profit after taxes expressed as a percentage of its outstanding shares. As an illustration, the EPS for a corporation with ten million outstanding shares and a profit of one hundred million dollars ($100M) would be $10.

P/E stands for price to earnings and is calculated by dividing the share price of a company’s stock by its earnings per share. Assuming the company is now trading at $100 per share and using the earnings example from before (EPS = $10), the P/E would be 10.

Let’s now put everything together to show how to comprehend and apply the rule.

1) Determine the average earnings per share for the last three (3) years. In other words, average a company’s earnings per share over the previous three years (i.e., 2020, 2021, and 2022). Call it the “average EPS.”

2) Subtract the current price of the company from the average EPS calculated in step one.

3) Assess – if you divide the current stock price of the company by its average earnings per share, and the result is equal to or less than 15, you may have discovered an undervalued business.

This could initially look difficult, but it’s really fairly simple. Let’s look at an example to show how simple it can be. Berkshire Hathaway, owned by Warren Buffet, serves as a particularly suitable illustration. We can look into some fundamental details about Berkshire Hathaway using your online stock brokerage (you can also use many other free tools like Yahoo Finance and Google Finance). Also, since a company’s financials are public records, you can research them online using the EDGAR database (for US stocks).

The cost and annualized earnings of Berkshire Class A shares as of this writing are:

Pricing at this time: $527,750 (And no, this is not a typo.)

Profits per Share in 2022 Will Be -$15,540.00

Profits per Share in 2021 = 59,460.00

Profits per Share for 2020 are $26,670.00.

Calculating the average EPS and P/E is the next step. According to the aforementioned data, the average EPS for the most recent three years is $23,530. If you divide the average EPS by the current stock price, you get a P/E ratio of 22.4.

It may appear at first glance that Berkshire Hathaway (stock code BRK.A) is not undervalued, but this may be viewed from two angles. One, while being slightly above the P/E ratio of 15, this might be viewed as a value buy due to the size and “diversified” assets portfolio that Berkshire Hathaway represents.

Another way to put it is that Berkshire Hathaway is entertaining to watch! Although the price at the moment is slightly over what we would consider to be a value company, why not set a buy price and try to catch BRK.A when it dips to a P/E ratio of 15?

Rule #2 – Book Vs Market Value

The price to book ratio, also referred to as the second guideline we’ll look at, is the measurement of a stock’s current price in relation to its book value (i.e., the company). the following is the rule:

A stock is deemed a value stock if its current price is less than or equal to one and a half times (1.5x) the company’s book value per share.
Alternatively stated:

This stock is regarded as a value stock if the P/B (price to book value ratio) is less than or equal to 1.5.
Let’s dissect and comprehend the fundamental elements of the second rule in order to comprehend what we mean.

Similar to the first rule, the current stock price is indicated below. If you were to buy the shares, you would pay this amount.

Simply said, book value (on a per-share basis) is the amount that a firm would be worth if all of its assets were added together and all of its liabilities were subtracted from it (i.e. things like debt, or claims to senior equity). Items like patents and goodwill are often not included in a company’s assets because they are intangible assets (non-physical in nature, as opposed to something like property, or cash, which are considered tangible assets). The best and simplest method to understand book value is to consider what would happen if the firm you are investing in were to close down, sell everything, settle all of its debts and liabilities, and then retain any remaining cash or value.

The price of the stock (share price) divided by the book value (per share) of a corporation is known as the P/B (price to book value per share ratio). For instance, if Company ABC had a market capitalization of $100 and a book value per share of $90, the P/B ratio would be 1.11.

Perhaps, this rule is easier to understand than rule #1, but if not, don’t worry. Let’s go through an example to show how simple it is, similar to rule #1. Let’s utilize Berkshire Hathaway once more in this illustration for consistency’s sake. We can look into some fundamental details about Berkshire Hathaway using your online stock brokerage (remember, you can also use many other free tools like Yahoo Finance and Google Finance).

Price and book value of Berkshire as of this writing are:

Pricing at this time: $527,750

$346,899 is the current book value per share.

As a result, we can state that the P/B is 1.52 given the current price/current book value per share. This suggests that Berkshire is currently a bargain company using this criterion since it is somewhat higher than BRK.A’s average P/B over the previous few years.

POTENTIAL VALUE STOCKS

 

Now that you are armed with two important value investing guidelines, you can search for stocks of businesses that meet these requirements. We would want to point out that while our two value investing rules of thumb are excellent value indicators, they are not the be-all and end-all.

Although it is primarily a science, value investing is also an art. You must invest the necessary time in research in order to develop both these scientific and artistic skills.

This is a list of stocks that we recently determined to fulfill one (or both of the above criteria), making them suitable Canadian value investing buys (although we aren’t necessarily recommending them on that basis alone). This list is provided to get you started on your journey.

See whether you arrive at the same valuations for these stocks as we did by looking at them (or come up with something slightly different due to updated data). It is important to note that neither MillionDollarJourney.com nor Myself are investment advisers. We don’t offer specialized or particular investment advice.

The information provided below is for informational purposes only and is not intended to be a personalized suggestion or advice regarding the suitability or wisdom of buying, selling, or investing in any specific investment, security, portfolio, commodity, transaction, or investment strategy.

BEST VALUE STOCKS IN CANADA: OUR TOP 10

There are many more Canadian value companies to choose from because the Canadian market is now discounted in comparison to its US rivals. The financial sector is well represented on this list, as you’ll see. That wasn’t a mistake. See our post on the top Canadian bank stocks for additional details.

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SHOULD I INVEST IN CANADIAN VALUE STOCKS?

Eventually, you must determine whether an active portfolio strategy is appropriate for you before selecting whether or not to invest in Canadian value stocks (or, for that matter, worldwide value stocks). Value investing, like picking growth stocks or the top dividend stocks in Canada, involves a lot more knowledge and research than following a straightforward index investing strategy and buying one of the all-on-ETFs available in Canada.

It’s crucial to remember that while we’ve covered some basic value investing principles here, there is still much to learn about both business fundamentals and the psychological aspects of investing if one is to become a successful long-term value investor.