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The Top 200 Canadian Stocks for 2007

Want to go hunting for buried treasure? Then join us as we once again dig up the shiniest prospects among Canada's largest 200 stocks in the third annual MoneySense Top 200.

We're pleased to say that the first two versions of the Top 200 have been a great success. Look, for instance, at our All-Around All-Stars from last year. These were the handful of stocks that scored well for both good value and good growth prospects. Since we selected them in November 2005, they have gone up in price by an average of 37.6%. Fold in the 57.6% return from the 2004 version of the All-Around All-Stars and our top picks are up 116.8% over the past two years. Yes, you heard that right. Someone who invested in our All-Around All-Stars from 2004 then rolled their gains into our top picks from 2005 would have more than doubled their money in two years - and their 116.8% gain doesn't even include the dividends they would have collected along the way.

As you might imagine, we are very happy with our results, but we want to stress that hunting for good stocks can be a hit or miss business. We've struck gold over the last two years, but we fully expect to stumble into an empty vault from time to time. As weathered veterans, we know that nobody can expect 37.6% returns as a matter of routine. We're keenly aware - and you should be too - that our top picks this year might flop. Remember the immortal words of the financial commentator Tim McMahon, who once pointed out: "Risk-taking is inherently failure-prone. Otherwise, it would be called sure-thing taking."

While nothing's a sure thing, we hope our track record will whet your appetite for this year's 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 the coming year doesn't yield as much booty as last year, 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 begin by identifying the largest 200 companies in Canada by net sales. Using data supplied from the Bloomberg database, we then evaluate each stock, first for its attractiveness as a value investment, then on its appeal as a growth investment. (What's the difference you ask? Value investors like beaten-down stocks that trade at low multiples of book value and pay juicy dividends. In contrast, growth investors like companies that are rapidly expanding their revenues and earnings.) Our value and growth screens employ some rather sophisticated measures of financial merit, but in the end we reduce everything about a stock to two simple letter grades - one grade for its value appeal, another grade for its growth potential.

The grades work just like they did back when you were in school. Highly polished top-of-the-class stocks earn an A. Solid but unspectacular stocks get by with a B or a C grade. Tarnished prospects languish with a D or even an F. The select group of stocks that manage to achieve either A or B on both the value and growth tests make our All-Around All-Stars list.

Only seven stocks fit into that exalted list this year. Four are making repeat appearances. E-L Financial and Kingsway Financial both got A's for value and growth last year and, after generating market-beating returns, earned double-A's once again this year. Russel Metals also earned double A's last year. It remains an A prospect for growth, but after shooting up 49.1% over the past year, not including dividends, its value grade has slumped to a B. Manitoba Telecom hasn't done much over the past year (other than provide a generous 6% dividend, that is), but still earns a B for value and an A for growth.

A couple of last year's All-Stars dropped off the list entirely for different reasons. The first was CHUM, which was bought out by Bell Globemedia at a hefty 59.1% premium to last year's price. The other was Enerflex, our only loser from last year's All-Stars list, which had the misfortune of converting into an income trust and running into the jaws of the taxman. Finally, we'd be remiss not to mention Aur Resources which was last year's most profitable All-Star with a 126.1% capital gain. Due to its massive run, Aur only managed a C grade for both value and growth this year.

As last year's results demonstrate, success isn't guaranteed for each and every stock on our list. If you're looking to make a quick buck from short-term trading, our system isn't for you. But if you're looking for a sane and objective take on any large Canadian stock, and if you're prepared to take the time to build a well-diversified portfolio, we think you'll find the Top 200 to be an invaluable way to generate promising investment ideas. Here's the lowdown on how we rated each stock:

The value test

Value investing is all about finding relative safety at a good price. 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 to sell off all the company's assets, at their balance-sheet value, and pay off all the firm's debts. 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.

Companies rarely go bust while profits are rolling in, so we awarded higher scores to firms that had positive price-to-earnings ratios over the past year (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 year (this is known as the forward P/E ratio).

Because it can take a while for the market to notice value stocks, we want to be paid to wait. So we awarded extra marks to dividend-paying stocks. Furthermore, to ensure a company wouldn't be sunk by excessive debt, we penalized companies living on credit. Instead, we awarded the best grades to firms with low leverage ratios (the ratio of assets to stockholders' equity) compared to their peers. Finally, we combined all these factors into a single value grade. Only 18 out of 200 stocks earned an A.

The growth test

The first mark of a good growth stock is, not surprisingly, growth. We started by awarding high marks to any stock that achieved robust earnings-per-share and revenue growth over the past five 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, as measured by their ability to provide healthy total returns over the past year.

As great as growth is, we don't want to buy into fads, 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. Only those stocks with strong returns on equity compared to industry norms earn 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 net sales. We figured that low to moderate P/S ratios indicate stocks that are reasonably priced, so we awarded them extra marks. In contrast, firms with high P/S ratios may be "concept" stocks that have generated a lot of hype, but little in the way of actual sales.

Putting all these growth and quality indicators together, we arrived at a final growth grade. Only 16 out of 200 stocks earned an A.

A caveat

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 recent developments.

Remember the built-in limitations of screens. For instance, if a company ran into trouble a few weeks back - say the government suddenly decided to levy a new tax on its earnings - 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.

The best way to use the Top 200 is as a starting point for your own investigations. You can focus in on the top-rated stocks or you can build your own list by looking up the growth and value characteristics that mean the most to you. If you're interested in stocks that sport high dividend yields and low price-to-earnings ratios, for instance, it's a simple matter to grab a pencil and underline a few choice stocks. Like any screening method, the purpose of the Top 200 is to help you dig through the stock market for a few possible treasures, which can then be examined in more detail.

From the December/January 2007 issue

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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...