Top 200 Canadian stocks (2010)

It has been a banner year for the Top 200. The stock market bounced back nicely from its March low and our top stocks have fared even better. Just as we advised, last year provided some truly tantalizing buying opportunities.

It all seems easy in retrospect but, as you well know, it was anything but. It takes more than a little nerve to buy stocks in the middle of a panic. It’s one thing to acknowledge that the best bargains appear in bear markets, but it’s quite another to buy when the rest of the world is selling. If you braved the markets and bought in near the bottom, congratulations — you’ve likely been handsomely rewarded.

If you bought last year’s Top 200 All-Stars, you fared particularly well. These stocks scored well on both their value and growth prospects. We selected them last November and they’ve gained an average of 41% since then, not including dividends. Over the same period, the S&P/TSX Composite (XIC) advanced 7.5%, so our All-Stars beat the index by an impressive 33.5 percentage points.

Our five-year results are similarly stellar. If you had bought equal amounts of the All-Star stocks and rolled your capital gains into the new team each subsequent year, you’d be sitting on a 19% average annual return. By way of comparison, that’s more than 14 percentage points higher than the annual return of the S&P/TSX Composite, which sported 4.7% annual gains over the same period.

It’s been quite the ride, and it got me to reminiscing. Several years ago a former professor of mine came to visit with my performance record in hand. “Did you know that you’ve outperformed most mutual funds?” he asked. I didn’t. But it was a gratifying observation. That memory prompted me to look up Canada’s mutual fund performance over the past five years. It turns out that the Top 200 All-Stars beat every single Canadian equity mutual fund over that period. We topped the best by about 3 percentage points a year and the second best by about 7 percentage points a year. The median Canadian equity fund trailed by 14 percentage points a year.

To be fair, the comparison is not entirely precise. The performance period in question doesn’t match exactly, although it’s close. The Top 200 started life in the middle of October, and this year’s list was reformed in early November, whereas only month-end performance figures are available for mutual funds. Also, we haven’t included trading commissions which, although low these days, vary from investor to investor. As well, no mutual fund invests in only a small handful of stocks because concentrated portfolios tend to be volatile. On the other hand, the gains of the All-Stars don’t include dividends, whereas the fund returns do.

As you might imagine, we’re very pleased with our performance record, but we want to stress that uncovering good stocks can be a hit-or-miss business. We’ve done well over the last five years, but we fully expect to stumble from time to time. As veteran market watchers, we know that nobody can expect 41% returns as a matter of routine. We’re keenly aware—and you should be too—that our top picks could fall flat this year.

Still, while nothing is a sure thing, we hope our track record will whet your appetite for this year’s Top 200. We took a hard look at Canada’s largest companies and graded each of them for their investment appeal. Our sixth annual MoneySense Top 200 is designed to be easy to use, logical, and appealing to all types of investors. In fact, we think the Top 200 provides you with a more objective look at large Canadian stocks than you’re likely to find from any other source.

Among other virtues, the Top 200 offers a very honest approach to selecting stocks. Our results are based entirely upon the numbers. Our feelings and opinions about a company don’t influence the grades.

To arrive at the Top 200 grades, we begin by identifying the largest 200 companies in Canada by revenue. Using data supplied from Bloomberg, we evaluate each stock, first for its attractiveness as a value investment, 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 screens employ sophisticated measures of financial merit, but in the end we reduce everything about a stock to two grades: one for value appeal, one for growth potential.

The grades work just like they did back when you were in school. The best stocks earn an A. Solid students get by with a B or a C grade. Those in need of improvement go 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 it to our All-Stars list. Only 16 stocks made the team this year.

But before we talk about our new All-Stars individually, here’s the lowdown on how we rate all 200 stocks.

The value test

Value investors like solid stocks selling at low prices, so we begin by looking for stocks 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 their 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, as well as a low ratio compared to its peers 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. So, 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. Investors looking for income should pay particular attention to such stocks. Canadian dividends offer tax advantages and stocks that pay them tend to outperform.

To ensure a company won’t capsize from excessive debt, we penalize companies for living on credit. We award the best grades to firms with low leverage ratios (defined as the ratio of assets to stockholders’ equity) compared to their peers.

Finally, we combine these factors into a single value grade. Only 20 out of 200 stocks got an A for value this year.

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 robust earnings-per-share and sales-per-share growth over the past three years. (This year, even a small amount of earnings growth was something of a feat.) We also track each firm’s growth in total assets over the past 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 don’t want to buy into fads, so we hedge our bets by checking out each stock’s return on equity. This important 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 earn our 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 have become detached from sensible expectations and could be due for a correction.

Putting these growth and quality indicators together, we arrive at a final growth grade. Only 20 out of 200 stocks earn an A for growth this year.

The All-Star team

After we crunched the numbers and awarded our letter grades, we found 16 stocks that earned at least one A and one B on our value and growth tests.

We were pleased to see three stocks that returned from last year’s All-Star list. The returnees are Velan (VLN), High Liner Foods (HLF), and Canadian Tire (CTC.A).

Velan produces industrial valves and hails from Montreal. It was the only stock to pick up an A for both value and growth last year and it remains highly ranked this year. High Liner Foods, from Lunenburg, N.S., serves up seafood to millions and good value to investors. Canadian Tire’s earnings held up quite well given the economic headwinds, but its stock is down more than 35% from its 2007 highs. This sharp drop in price may offer you the opportunity to “save like Scrooge” by snapping up a few shares.

Three new retailers join Canadian Tire on the All-Star team this year. Leon’s Furniture (LNF), originally of Welland, Ont., sells furniture, appliances and electronics. It has an enviable growth record and currently represents good value. Sporting goods retailer Forzani (FGL) just squeaked through despite slipping into the red in recent quarters. But it usually scores big profits in the holiday season. Our last retailer is Indigo Books & Music (IDG), which has a lock on the big bookstore business in Canada. The company is in an enviable position now, but it may be difficult to maintain its monopoly due to looming threats from the Internet.

Our largest All-Star company is insurance firm Fairfax Financial (FFH), which is run by value investor extraordinaire Prem Watsa. Remarkably, Watsa guided the firm to profitability both as the markets fell and as they rebounded. Based on his recent record, it’s no wonder that he is referred to as the Warren Buffett of the North. But, as a long time shareholder, I could be a little biased.

Uni-Select (UNS) and TVA Group (TVA.B), two Quebec-based firms, scored top marks for both value and growth this year. Uni-Select runs the leading auto-parts distributor in Canada and is rapidly expanding 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.

Premium Brands (PBH) of Richmond, B.C. serves up specialty foods in the West. It also recently converted from an income trust into a stock. Lassonde (LAS.A) makes and markets fruit and vegetable juices in Canada. It also imports foreign wine to quench the thirst of Canadians.

ATCO (ACO.X) is a utility and energy conglomerate run out of Alberta. Aecon (ARE) is a large Canadian construction and infrastructure development company, which should benefit from the recent stimulus spending.

Rounding out this year’s All-Star list are Dorel (DII.B), Viterra (VT), and IESI-BFC (BIN). Dorel makes bicycles and products for children, Regina-based Viterra delivers grain and agri-products worldwide, and IESI-BFC cleans up in the solid waste management business.

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. Read the firm’s latest press releases and regulatory filings. Scan newspaper stories to make sure you’ve figured out all the important developments and breaking news. That way you’ll be more comfortable with your holdings and increase your chances of success.

Norm Rothery, PhD, CFA, is the founder of StingyInvestor.com. He holds some of the securities mentioned in this story.