Hedge funds employ huge arrays of computers using elaborate and arcane mathematics to measure stocks and markets. But does this give them an unfair advantage over an average investor or financial advisor? Not at all.

For the individual, simple arithmetic works better. And if you are seeking long-term value and growth, you need only basic measurements. One of these is the ratio of stock price to book value of shareholders’ equity.

The data you need are straightforward: current stock prices and book value per share figures for the latest fiscal year of the companies you want to study. If your Grade 8 arithmetic is not too rusty, you don’t even need a calculator to figure out which stocks are relatively cheap and which are relatively expensive.

When you survey a sample of Canadian non-resources stocks today, you will find most are cheaper than they have been in the past five years. But they are still not dirt cheap. The benchmark is a price of about 1.5 times book value. Stocks trading above that level are not bargains unless they are especially cheap by other measures, such as the price/earnings multiple.

The source of this criterion is Ben Graham, who had it figured out 60 or 70 years ago. “In the stock market, the more elaborate and abstruse the mathematics, the more uncertain and speculative are the conclusions,” he said at the time, sounding as if he had today’s hedge funds in mind.

There is plenty of evidence to show that portfolios of stocks bought at low price/book value multiples do better than stocks bought at high multiples in the long run.

The selection shown in the accompanying table avoids today’s hot stocks in the resources industries. Instead, the examples focus on industries analysts think will be “defensive,” or able to withstand the worst of any market shock. These groups include banks, utilities and pipelines, and consumer-related industries.

The ratios show banks are still highly valued, with an average price/book ratio of 2.5 times, compared with their average five-year high valuation of 2.6 times.

In contrast, food and food retailing stocks trade closer to their low five-year valuations. Part of that has to do with the price drop seen in the shares of George Weston Ltd. and the embattled Loblaw Cos. Ltd. supermarket chain it controls. At little more than twice book value, these two stocks are less risky than when they traded at five times book value.

Utilities were bargains at their average five-year lows, when share prices approximated book values. Now the group trades at more than twice book value, compared with a five-year average high of 2.5 times.

The utility ratios reflect growth. Companies with the lowest dividend growth, Emera Inc. and TransAlta Corp., trade at the lowest price/book value multiples, while Fortis Inc. stands out as the likeliest bargain in relation to its dividend growth.

The low price/book value experience became degraded in the great bull market of the 1980s and 1990s because growth stocks flourished. And the basic identifying characteristic of a growth stock is a high price/book value multiple.

Price/book value measurement is going to become a much more useful tool for investors when business growth slows or stops. As stock prices drop in anticipation of this, the impact will be softer on stocks with already low price/book valuations.

That is because a stock priced close to its presumed liquidation value — what would be left if all assets were sold and liabilities liquidated at book value — has little expectation built into its market price. Such stocks are thus less susceptible to a devastating price drop.

Mind you, one ratio alone is insufficient for making an investment decision. The price/book value ratio can lead you to stocks with a greater probability of future gains in value. It should be used as evidence leading to an investment decision.

Just the same, the experience of low price/book portfolios even in the “go-go” era is impressive.

James O’Shaughnessy, an American who manages a group of mutual funds in Canada for RBC Asset Management, came to the market’s attention with his book, entitled What Works on Wall Street. His massive research for the years 1952 through 1994 proved in detail the concept that buying stocks with low price/book value ratios cuts risk.

“Over the long term, the market rewards low price/book ratios and punishes high ones,” he says. IE

@page_break@