The top 200 for 2006
rating every major Canadian stock
Good stocks are hard to find, so a year ago we decided to provide our readers with a helping hand. We ranked the 200 largest stocks in Canada in our first annual MoneySense Top 200. We figured that our top-rated stocks might provide you with a few good starting points for your own research.
We're pleased to say that our modest experiment succeeded beyond our wildest dreams. Our highest-ranked stocks gained an average of 57.6% since we picked them. That's right, you read correctly. We said 57.6%. Even our second-tier picks thumped the market by double-digit amounts.
We like praise as much as the next guys, so we'll happily accept whatever compliments you might want to throw our way. We do insist, though, on inserting a note of caution. Nobody - not Warren Buffett, not George Soros, certainly not Donald Trump - produces 57.6% returns as a matter of routine. We're keenly aware that our top picks this year might flop.
Still, we hope that last year's spectacular gains will whet your appetite for a peek at the 2006 version of the Top 200. We've worked hard to produce a ranking system that's easy to use, logical and appealing to all types of investors. Even if this coming year doesn't produce results quite as dazzling as last year's, we think the Top 200 will still provide you with a more objective, more insightful look at large Canadian stocks than you're likely to find from any other single source.
To arrive at the Top 200, we began by identifying the 200 largest companies in Canada by revenue. Using data supplied from the Thomson Baseline database, we then evaluated each of these firms using two stock evaluation screens - one to test its attractiveness as a value investment, the other to evaluate its appeal as a growth investment. Both screens incorporated several sophisticated measurements of financial virtue, but in the end we reduced everything to simple letter grades.
The grades work just the way they did back when you were in school. Top-of-the-class stocks earn an A. Solid but unspectacular stocks get by with a B or a C grade. Bottom-of-the-heap prospects slink away with a D or even an F. The select group of stocks that manage to achieve at least an A or a B on both the value and growth tests make our All-Around All-Stars list.
You may want to pay special attention to these All-Stars. As noted above, the All-Around All-Stars from last year gained an average 57.6% from Oct. 15, 2004, when we selected them, through to Nov. 1, 2005. This mind-boggling performance doesn't even include dividends. And what was interesting to us was how well our second-tier and more diversified selections performed. Our average A-grade value stock brought in capital gains of 34.1%, while our average A-grade growth stock managed gains of 33.8%. Both lists of A stocks finished far ahead of the overall Canadian market, which enjoyed a healthy 18.2% capital gain, but nothing close to the results of our top-rated stocks.
Before you get too excited, let us emphasize again that we're not saying that you can expect such juicy returns in the future. The market just isn't that predictable. But we do think we've proven our basic point. It's clear that a series of quantitative tests, such as the ones we've used here, can help pinpoint promising stocks. Stocks that get an A grade deserve your attention and your further research. They have the fundamental ingredients for success. On the other hand, you should be wary of F stocks.
You can adapt our system in many ways. At its heart, of course, is the distinction between value investing and growth investing. Value investors typically like beaten-down stocks, trading at low multiples to their book value and earnings. In contrast, growth investors like companies that are rapidly expanding their revenue and earnings. Our Top 200 awards each stock one grade for its value appeal and a second grade for its growth attractiveness, so no matter which way you lean, you can easily find a list of stocks that should appeal to you.
Note, however, that our grades are more about long-term potential than short-term market psychology. If you're looking to make a quick buck from short-term trading, our grading system isn't for you. But if you're looking for a sane and objective take on a large Canadian stock, we think you'll find the Top 200 to be an invaluable way to generate promising investment ideas. To prove there's no favoritism involved, here's the lowdown on how we rated each stock:
The value test
The two things you want in value stocks are low, low prices and relative safety, so we graded each stock accordingly. For starters, we looked at each stock's price-to-book-value ratio (P/B). This measures a stock's price compared to how much it would be worth if you were able to sell off all the company's assets, at their balance-sheet value, and pay off all the firm's liabilities. To get top value marks, a stock had to possess a low price-to-book-value ratio in comparison to other stocks and also to its peers within the same industry.
To test for safety, we began by investigating each company's bottom line. Since companies rarely go bust while profits are rolling in, we awarded higher scores to firms that had positive price-to-earnings ratios over the past 12 months (this backward-looking figure is known as the trailing P/E ratio). We also rewarded a company if industry analysts expected it to have a positive P/E over the next 12 months (this number is known as the forward P/E ratio).
But that's not all. Because dividends provide income and are a big factor in generating a stock's total return, we boosted the score of dividend-paying stocks. To ensure a company wouldn't be sunk by excessive debt, we penalized spendthrift companies living on credit. Instead, we awarded the best grades to firms with low leverage ratios (defined as the ratio of total assets to stockholders' equity). Finally, we combined all these factors into a single value grade.
Only 22 out of 200 stocks earned an A.
The growth test
The first mark of a good growth stock is, not surprisingly, growth. So we started by awarding high marks to any stock that achieved above-median earnings-per-share and revenue growth over the past three years. We also wanted to be sure that the market was taking note of this improving situation, so we handed out additional marks to stocks with strong price momentum. In particular, we favored stocks that yielded above-median total returns over the past year.
As great as growth is, we don't want to buy into fads or one-hit wonders, so we hedged our bets by checking out each stock's return on equity (ROE). This vital statistic measures how much a firm is earning compared to the amount that shareholders have invested. It is an important indicator of the quality of a business. Only those stocks with healthy returns on equity compared to industry norms earned our top marks.
Finally, since no one wants be the last buyer in a bubble, we examined each stock's price-to-sales ratio (P/S). This ratio measures the stock's price in comparison to the company's sales. We figured that low to moderate price-to-sales ratios indicate stocks that are reasonably priced, so we awarded them extra marks. In contrast, firms with high price-to-sales ratios may be "concept" stocks that have generated a lot of hype and excitement, but little in the way of actual sales.
Putting all these growth and quality indicators together, we arrived at a final growth grade.
Only 19 out of 200 stocks earned an A.
Before buying any stock on the basis of our grades, you should make sure the company's situation hasn't suddenly changed in some important way. Read the firm's latest press releases, regulatory filings, and scan newspaper stories to make sure you're up to speed on all of the most recent developments.
Remember the built-in limitations of screens. If a company ran into trouble a few weeks back - say its refinery was swept away by a hurricane - its stock can look like a bargain because the current share price will be cheap in comparison to the firm's past success. But the past results won't reflect the current reality.
Furthermore, screens can't take into account every company's unique situation. For instance, Hudson's Bay earned a value grade of A and a growth grade of D. Problem is, the Bay's largest shareholder, U.S. financier Jerry Zucker, recently launched a hostile takeover bid for the entire company. Zucker is currently offering $14.75 per share for the storied firm, but he seems willing to up the ante should management become more cooperative. Speculation that the bid will be increased has pushed the Bay's stock to $15.34 per share - well above the hostile bid price. However, our grading methodology does not take into account takeover bids. So, be sure to consider the unique circumstances surrounding each stock before investing.
The best way to use the Top 200 is as a starting point for your own research. You can focus in on only the top-rated stocks or, if you know what you want, you can easily look up the growth and value characteristics that mean the most to you. If you're interested in stocks with low P/B ratios and high revenue growth, for instance, it's a simple matter to grab a pencil and underline a few choice stocks. Similarly, if you're already keen on a particular stock but want to see if it has a strong return on equity, that data is also available in our downloadable Excel spreadsheet. Like any screening method, the purpose of the Top 200 is to help you distill the wide universe of stocks into a few good ideas, which can then be investigated in more detail.
From the December/January 2006 issue of MoneySense magazine.
|Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...|