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The Top 200 Canadian Stocks for 2011

As most seasoned investors know, beating the market isn't as easy as it looks. Few amateur investors can do it for even a year or two. Despite their high six-figure salaries, most of the top mutual fund managers on Bay Street find themselves faltering after a just few years. But beating the market was the lofty goal we set ourselves with the MoneySense Top 200 All-Stars. And this year, we're pleased to announce that we've done it again. In fact, in this, the seventh year of our stock-picking adventure, our Top 200 All-Stars cruised to an easy one-year gain of 19.7% - soundly trouncing the S&P/TSX Composite Index (XIC) by a full 5.5 percentage points. Even more impressively, when you look at our five-year performance history, you'll find that we have once again outperformed every single Canadian equity mutual fund.

As it happens, this was about an average year for our top stocks. If you had bought equal amounts of the All-Stars and rolled your gains into the new players each year, you'd now be sitting on a 19.1% average annual return over the last six years, not including dividends. By way of comparison, that's more than 12 percentage points higher than the annual return of the S&P/TSX Composite (XIC), which climbed just 6.5% a year over the same period.

Last year we found that our All-Stars bested every single Canadian equity fund over the prior five years. Well, we couldn't resist making the comparison again. When we did, we discovered that over the last five years, our All-Stars beat the best Canadian equity fund (in either the pure or focused categories) by nearly two percentage points a year - and the second best fund by more than three percentage points a year. The S&P/TSX Composite, meanwhile, trailed by more than eight percentage points annually.

To be fair, the comparison isn't completely precise. For instance, the performance period in question doesn't match exactly. It's off by a few days because we don't recruit our team at exactly the same time each year. Also, we haven't included trading commissions which, although low these days, vary from investor to investor. On the other hand, our gains don't include dividends - whereas active-fund returns do - so we don't think we're being too unfair to the funds.

We're very pleased with our performance record. As you can see in Capital Gains, if you had split $100,000 equally among our original All-Stars six years ago, then sold them and rolled your gains into the new batch each year, your portfolio would now be worth $285,000 - almost triple your original investment. Still, we want to stress that while we've done very well over the last six years, those kinds of gains don't come without risk. That means it's almost inevitable that we will eventually run into a soft patch. We believe that our stock picking methodology works well over the long term, but we're keenly aware - and you should be too - that we can't predict the future from year to year. That means it's quite possible that this year's All-Stars could disappoint.

While nothing's a sure thing, we hope that our track record will whet your appetite for this year's Top 200. As in prior years, we put each of Canada's 200 largest companies through its paces and graded each one on its investment merit. We deliver an easy-to-use scorecard packed full of just the sort of information that appeals to most investors. In fact, we think the Top 200 gives you a more objective look at large Canadian stocks than you're likely to find from any other single source.

Importantly, the Top 200 offers a logical and consistent approach to selecting stocks that isn't influenced by feelings or fleeting fads. Nor do we rely on gut instincts or happy visions of the future. Instead, our results are based entirely upon the numbers. Our opinions about a company don't enter into it.

We begin by identifying the largest 200 companies in Canada by revenue. Using Bloomberg data, we evaluate each stock, first for its attractiveness as a value investment and then on its appeal as a growth investment. (Value investors like profitable stocks that trade at low multiples of book value and pay juicy dividends. Growth investors like companies with momentum and expanding earnings.) Our value and growth tests are driven by sophisticated calculations, but in the end we reduce everything about a stock to two grades: one for its value appeal, one for its growth potential.

The grades work just like they did back when you were in school. The best competitors are awarded an A. Solid athletes get by with a B or a C. Those in need of improvement go wheezing home with a D or even an F. A select group of stocks - those that manage to achieve at least one A and one B on the value and the growth tests - make our All-Star team. Only 12 stocks got the honour this year. But before we talk about the new All-Stars, here's how we rate all 200 stocks.

The value test

Value investors like solid stocks selling at low prices, so we begin by looking for those with low price-to-book-value ratios (P/B). This number compares the market value of a company to how much cash you could raise by selling off the company's assets (at balance-sheet prices) and paying off the firm's debts. Low P/B ratios provide some assurance that you're not paying much more for a stock than its parts are worth. To get top value marks, a stock has to possess a low price-to-book-value ratio compared to the market and also compared to its competitors within the same industry.

We also like to track price-to-tangible-book-value ratios. Tangible book value is like regular book value, but it ignores any intangible assets (such as goodwill) a firm may have. It's an even sterner test of how much a company would be worth if it had to be closed down and sold off for scrap.

Other factors matter, too. Good companies produce profits, so we award higher scores to firms that have positive price-to-earnings ratios (this backward-looking figure is known as the trailing 12-month P/E ratio). We also reward a company if industry analysts expect it to be profitable and have a positive P/E over the next year (this number is known as the forward P/E ratio).

Because we like our investments to pay, we award extra marks to dividend-generating stocks - the stocks that dish them out tend to outperform. To ensure a company won't capsize from excessive debt, we penalise companies living on credit. We award the best grades to firms with low leverage ratios (defined as the ratio of assets to stockholder's equity) compared to their peers. Finally, we combine these factors into a single value grade. Only 21 stocks got an A this year.

Value Team

The growth test

The first mark of a good growth stock is, not surprisingly, growth. We start by awarding high marks to any stock that achieved good earnings-per-share and sales-per-share growth over the past three years. (Given the recession, even a bit of earnings growth was something of a feat this year.) We also track each firm's growth in total assets since last year to get a sense of recent trends.

We want to be sure that the market is taking note of a company's improving situation, so we hand out additional marks to stocks that are strong performers relative to other stocks. In particular, we favour stocks that have provided good total returns over the past year.

As great as growth is, we hedge our bets by checking out each stock's return on equity. This statistic measures how much a firm is earning compared to the amount that shareholders have invested. It is a key indicator of the quality of a business. Only those stocks with healthy returns on equity compared to others in their industry get top marks.

Finally, since no one wants be the last buyer in a bubble, we examine each stock's price-to-sales ratio. This ratio measures the stock's price in comparison to the company's sales. Low to moderate price-to-sales ratios indicate stocks that are reasonably priced and we award them extra marks. In contrast, firms with high price-to-sales ratios may be glamour stocks that could disappoint.

Putting these growth and quality indicators together, we arrive at a final growth grade. Only 21 out of 200 stocks earned an A this year.

Growth Team

The All-Star team

As we mentioned previously, only 12 stocks earned at least one A and one B on our value and growth tests.

We are pleased to see six of last year's All-Stars make the cut again this year. The veterans are: ATCO (ACO.X), Dorel (DII.B), Fairfax Financial (FFH), High Liner Foods (HLF), Leon's (LNF), and TVA Group (TVA.B). The new additions are: Alimentation Couche-Tard (ATD.B), AutoCanada (ACQ), Domtar (UFS), Goodfellow (GDL), Groupe Aeroplan (AER), and Magellan Aerospace (MAL).

High Liner has been on the All-Star team for the last two years and has climbed more than 57% since it debuted. It is also one of only two firms to get an A for both value and growth this year. As a result, the firm from Lunenburg, N.S., which serves up seafood to millions, remains a succulent investment.

ATCO is a sprawling utility and energy conglomerate run out of Alberta and is our second double-A stock this year. We've followed this firm for years and have come to appreciate its persistent dividend growth.

Our largest All-Star, by market capitalization, is the insurance firm Fairfax Financial which is run by noted value investor Prem Watsa. Remarkably, Prem managed to guide the firm to profitability both as the markets fell during the great recession and as they rebounded. Based on his long-term record, it's little wonder that many call him the Warren Buffett of the north.

Leon's Furniture, originally of Welland, Ont., sells furniture, appliances and electronics. It also has an enviable growth record, considering its industry, and currently represents a good value.

Alimentation Couche-Tard runs more than 5,800 convenience stores across Canada and the U.S. under three main banners: Couche-Tard, Mac's, and Circle K. It is this year's largest All-Star by revenue.

Domtar, a Fortune 500 pulp and paper firm, nosed its way into this year's list because it trades on the TSX and has significant operations in both the U.S. and Canada. But patriots should note that it is officially domiciled in the United States.

TVA Group, a subsidiary of Quebecor Media, operates the largest private French language TV network in North America and sells a slew of consumer magazines.

Dorel makes bicycles and products for children, but don't be fooled by its diminutive clients - it raked in more than $2 billion in sales over the last 12 months.

Groupe Aeroplan runs loyalty management operations, including a frequent flyer miles program and the complicated data analysis behind it.

The last three members of this year's team are on the small side. As a result, they are best considered by more experienced investors.

Magellan makes parts for the aerospace industry. But it comes with a side of risk because it is building a facility for the new Joint Strike Fighter which has become a bit of a political football. Goodfellow, of Delson, Que., is in the glamorous business of selling lumber and hardwood flooring, largely in central and eastern Canada. AutoCanada of Edmonton, Alta., profitably runs more than a score of auto dealerships in six provinces.

Before you rush out to buy any stock, do your own due diligence. Make sure that its situation hasn't changed in some important way. Keep an eye out for stocks that trade infrequently- they deserve care. Read each firm's latest press releases and regulatory filings. Scan newspaper stories to make sure you're aware of important developments and breaking news. If you do, you'll be more comfortable with your team - and greatly increase your chances of success.

All-Star list

First published in the December/January 2011 edition of MoneySense magazine.


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