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Sculpting a portfolio by subtraction

Most stock pickers dive into the markets with a clear goal in mind. They want to find the stocks that have the very best qualities so they can make a fortune. Such searches often lead to the extremes of the market. Value investors seek stocks trading at extremely low earnings multiples. Growth investors hunt for firms with extraordinary histories of expanding revenues.

Rather than look for stocks at the extremes, I take a different tack. Instead of seeking the best, I endeavour to avoid the worst. It's like sculpting: I start with all the stocks on the Toronto Stock Exchange then slowly whittle down this long list through a series of relatively mild cuts.

The first slice is based on earnings. While most bargain hunters seek stocks trading at less than 12 times earnings, it turns out that stocks with every high earnings multiples - or no earnings - tend to fare quite poorly. To avoid them I carve off stocks with price-to-earnings ratios north of 25 and those with losses.

While the bottom line is an important gauge of a company's health, the top line is also telling. Stocks with very high price-to-sales multiples have horrendous long-term track records.

Firms with the highest 20 per cent of price-to-sales ratios underperformed the market by more than 4.8 percentage points from Jan. 1, 1964, to Dec. 31, 2009, according to James O'Shaughnessy's book What Works on Wall Street. That's why I steer clear of those trading for more than three times sales.

Moving beyond the income statement, I consider cash flow, which reflects the amount of money a company has flowing through its doors. In many ways cash flow represents the life blood of any business.

But instead of using simple cash flow from operations, I prefer to focus on a slightly different measure called free cash flow, which also takes into account capital expenditures. It's a rough measure of how much money a company could return to shareholders without letting its production facilities run down.

Once again, the goal is not to find stocks that produce gushers of cash, but simply to exclude undesirable firms. That means chipping off companies with negative free cash flows.

Now I consider a company's assets. Like most value investors, I have a fondness for stocks with very low price-to-tangible-book-value ratios. (Tangible book value is a measure of how much a company would be worth if you could sell off its assets - not including intangibles such as goodwill - and pay its debts at their balance sheet values.) To avoid the worst, I stick to stocks trading between zero and three times tangible book value.

It is also wise to discard companies that have a tendency to grow their share count significantly from year to year. Such growth might come from paying management too generously or from issuing shares to fuel an acquisition binge. Either way, it's a good idea to exclude companies that have grown their share count by more than 5 per cent over the past year.

The last two factors revolve around dividends. I like my investments to pay cold hard cash, which is why I carve away firms that don't pay dividends. But I also want to see these payments grow. As a result, it seems best to avoid firms that have failed to boost their dividends over the past five years.

Any one of the factors I've listed above is quite moderate in isolation. Put all of them together, however, and you wind up with a fairly restrictive screen. According to S&P Capital IQ, a mere 15 stocks on the TSX pass all the tests.

That speaks to the small size of our local market. To find stocks that fit a lengthy set of more demanding criteria, investors should be prepared to look abroad.

Sculpting for value
CompanyPrice (Nov. 16)P/EP/TBVYield
Airboss of America (BOS)4.3917.71.424.7
Algoma Central (ALC)118.909.21.012.0
CCL Industries (CCL.B)37.07 13.1 2.582.1
Canadian Natural Resources (CNQ) 27.26
Canadian Tire (CTC.A) 66.75 10.9 1.53 1.8
Empire Company (EMP.A) 56.48 10.7 2.24 1.7
Exco Technologies (XTC) 4.94 9.5 1.43 3.0
HNZ Group (HNZ.A) 19.605.0 1.54 5.6
Magna International (MG) 43.55 7.51.342.5
Methanex (MX) 28.68 20.3 1.90 2.6
Morguard(MRC) 103.49 3.4 0.70 0.6
Reitmans (RET.A) 11.82 18.11.796.8
Sherritt (S) 4.74 18.8 0.55 3.2
Suncor Energy (SU) 31.54 10.3 1.31 1.7
Winpak (WPK) 15.06 14.5 2.12 0.8
Source: Norman Rothery; S&P Capital IQ

First published in the Globe and Mail, November 21 2012.

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