The top 200 for 2005
rating every major Canadian stock
For most of us, evaluating a stock is more like gambling than science. We buy into a company because our broker tells us it's the next Microsoft. Or we load up on a firm's shares because our brother-in-law works for the company and talks up its prospects.
With all due respect to brokers and brothers-in-law, wouldn't it be nice if there were a deeper, more insightful, more precise way to size up a prospective investment? We thought so. And that's what we've delivered in the MoneySense Top 200.
Our approach is so simple to use that anyone who has ever read a report card can understand it. But despite its simplicity, the Top 200 delivers a sophisticated take on the markets. In fact, it's similar in approach to the way many professional investors search for stocks. These pros know the first step in finding potential winners is screening out probable losers. So they regularly screen every stock in the market to see if it meets the basic criteria they want in an investment.
What are those basic criteria? That depends upon the investor. A value investor (someone who's looking to buy beaten-down stocks at bargain prices) might screen for stocks that have low share prices in comparison to their earnings. On the other hand, a growth investor (someone who wants to buy stocks with the potential to soar past the market) might screen for firms that have expanded their sales rapidly over the past three years.
Our Top 200 caters to both the value and growth camps. We began by finding Canada's 200 largest companies on the basis of revenue. Using data supplied from the Thomson Baseline database, we then evaluated each of these big firms using two screens one to test its attractiveness as a value investment; the other to evaluate its appeal as a growth investment. Both screens incorporated numerous factors, but in the end we boiled each of these evaluation methods down to a single grade. 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. Bottom-of-the-heap prospects slink away with a D or even an F.
Before you get all excited, let us emphasize that we're not saying you can make a fortune by buying every A stock and dumping every F stock. The market just isn't that predictable. But we do think that A stocks deserve your attention and your further research. They have the fundamental ingredients for success. On the other hand, if your broker and your brother-in-law are touting an F stock, you should ask a lot of questions. What do they see in the company that isn't reflected in the numbers?
To help us all sleep better at night, we built a margin of safety into our grading scheme. Value stocks had to be relatively stable as well as just cheap to earn an A grade. Growth stocks had to be good quality firms as well as fast growing to merit a top ranking. If you're looking for lottery-like payoffs from day trading stocks, our grading system isn't for you. But if you're looking for a sane and objective take on any large Canadian stock, we think you'll find the Top 200 to be an invaluable way to check out hot tips and momentary enthusiasms, as well as to generate promising investment ideas. To prove there's no favoritism involved, here's the nitty-gritty on how we rated each stock:
The value test
The two things you want in a value stock are cheapness and safety, so we graded each stock accordingly. To gauge for cheapness, 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 to wind up the business, 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 on our screen, a stock had to possess a low price-to-book-value ratio in comparison to the rest of the market and also to its peers in the same industry.
To test for safety, we began by probing each company's bottom line. Since it's hard to go bust while profits are rolling in, we looked at each stock's price-to-earnings ratio over the past 12 months (this is known as the trailing P/E ratio) and awarded higher scores to firms that had positive ratios in other words, those that made a profit over the past year. We also rewarded a company if industry analysts expected it to have a positive P/E over the forward 12 months.
We weren't finished yet. Dividends can provide a significant part of your total return from holding a stock, so we raised a stock's score if it pays a dividend. And to ensure a company would not be sunk by excessive debt, we ruled out firms that were deep in hock. We awarded the best grades to companies with low leverage (defined as the ratio of total assets to stockholders' equity). Finally, we combined all these factors into a single value grade. Only 12 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 marks to any stock that had achieved above-median growth in its earnings per share and revenue over the past three years. We handed out additional marks to stocks with strong momentum in other words, stocks that achieved above-median total returns over the past year.
As great as growth is, we wanted to ensure we weren't buying fads or one-hit wonders, so we hedged our bets by taking a peek at 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 a crucially important indicator of the fundamental quality of a business. Only those stocks with healthy ROEs compared to industry norms earn top marks in our system.
Finally, since no one wants to be the last buyer in a bubble, we examined each stock's price-to-sales ratio (P/S). This measures the stock's price in comparison to the company's sales per share. We figured that low to moderate P/S ratios indicate stocks that have a solid foundation in real-world sales, 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, so we gave them nothing on this criterion.
Putting all these growth and quality indicators together, we arrived at final growth grades for each stock. Only 16 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. You should read the firm's latest press releases and its regulatory filings. You should also scan newspaper stories to make sure you're up to speed on all the most recent corporate developments.
Keep in mind the built-in limitations of screens. If a company ran into trouble a few weeks back if one of its factories burned to the ground, say its stock can look like a red-hot bargain because the current share price will reflect the disaster and seem cheap in comparison to the firm's past earnings. But that is a mirage that doesn't reflect current reality.
Furthermore, screens can't take into account every company's unique situation. For instance, Rothmans (TSX: ROC) earned a value grade of B and a growth grade of C on our screens. Problem is, the historical numbers don't reflect society's crackdown on smoking. As non-smoking forces gather strength and cancer patients look to the courts for satisfaction, Rothmans is facing a battery of threats from litigation, government regulation, taxation not to mention non-smoking bars. As a result, while Rothmans' financial results have been strong in the past, the company's future prospects may not be nearly so rosy.
The best way to use the Top 200 is as a starting point for your own research. Don't feel confined by our grading method. Instead, look up the growth and value characteristics that mean the most to you. If you're interested in stocks with low P/E ratios and high earnings growth, 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 positive price momentum, you can find that data in our tables. Like any screening method, the purpose of the Top 200 is to help you distill an ocean of stocks into a few good ideas, which can then be investigated in more detail.
These stocks score high in both value and growth.
From the Dec 2004 issue.
|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...