It\u2019s Time to Buy the Low-P\/E Stocks in the S&P\/TSX 60

Is it time for investors in Canada to apply a 25-year-old investment strategy to the S&P/TSX 60 Index?

The Globe and Mail contributor Norman Rothery recently wrote about a stock-picking strategy that invested in 10 stocks included in the Dow Jones Industrial Average (DJIA) with the lowest price-to-earnings ratios (P/E) each year.

Similarly to the “Dogs of the Dow,” an investor would buy the 10 stocks with the lowest P/E ratios. Hold them for a year. Then reconstitute and rebalance the portfolio at the end of the year. Rinse and repeat for decades.

According to data from James O’Shaughnessy’s 1997 investment bestseller, What Works on Wall Street, the 10 stocks with the lowest P/Es averaged an annual rate of return of 9.2% between June 30, 1937, and June 30, 2004, 220 basis points higher than the DJIA over the same 77 years. (To be fair, O’Shaughnessy’s strategy was an update of Benjamin Graham’s.)

Over the next 19 years, between June 30, 2004, and June 30, 2023, the 10 stocks with the lowest P/E generated an average annual rate of return of 8.3%, 80 basis points less than the DJIA.

While slightly lower in recent years, still very respectable returns.

O’Shaughnessy is no stranger to Canadian equities. The same year as his book was published, Royal Bank of Canada (CA:RY) launched the RBC O’Shaughnessy mutual funds for Canadian investors, with seven still traded.

What would that look like when applied to the main Toronto gauge?

Value Investing Never Completely Goes Out of Style

There have been many periods over the past 100 years where investors have completely neglected value investing. There have also been times when it was a favorite investor strategy.

Between 2013 and 2023, U.S. growth stocks averaged a 14.6% annualized return, 410 basis points higher than U.S. value stocks. However, between 2000 and 2010, a very slow period for stocks in general, value stocks generated an annual return of 3.64%, 589 basis points higher than growth stocks.

A well-constructed portfolio should always include a value component to offset periods where growth isn’t cutting it.

The easiest way to play Canadian value and growth stocks is to buy the iShares Canadian Value Index ETF (CA:XCV) or the iShares Canadian Growth Index ETF (CA:XCG). The exchange-traded funds track the Dow Jones Canada Select Value Index and the Dow Jones Canada Select Growth Index, respectively.

Over the past decade, the XCV generated an annualized total return of 7.74%, through July 10. That was 78 basis points less than the XCG.

Lowest 10 P/Es from the S&P/TSX 60

These top three holdings from XCV are Toronto-Dominion Bank (CA:TD), Royal Bank, and Enbridge (CA:ENB). The top three holdings of the S&P/TSX 60 ETF (CA:XIU), which tracks the performance of the S&P/TSX 60 Index, are Royal Bank, TD and Shopify (CA:SHOP).

Coincidentally (or, maybe not such a coincidence…) those top three XCV holdings garner similar Value Scores on Fintel’s quant dashboard, with ENB stock at 59.91, TD stock at 60.13 and RY stock at 61.71. That proprietary scoring model that ranks companies based on their relative valuation. Scores range from 0 to 100, with 100 being the most undervalued.

Here are the 10 lowest P/Es on the S&P/TSX 60:

The average of these 10 lowest P/Es is 6.60x. That’s considerably lower than both XCV at 9.97x and XCG at 19.34x.

Buy the 10 lowest today and reconstitute and rebalance them a year from now. Repeat that for the next decade, and you’ll find you’ve generated healthy returns.

Alternatively, you could allocate 50% of your investment capital to XCV and XCG, rebalancing annually.

Either way, as the Globe’s article suggests, this system implemented over the long haul will generate reasonable returns relative to the S&P/TSX 60.

This article originally appeared on Fintel

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