Alex Trochut
Do you ever suffer from information overload? It’s not surprising if you do. Thanks to the rise of Big Data and the proliferating digital sensors that feed it, we now produce about 2.5 quintillion bytes of the stuff every day, and that rate is accelerating—some 90% of the data floating around out there right now was produced in the past two years.
For more than three decades, Report on Business magazine’s Top 1000 report has been adding to that numerical stream with the most authoritative ranking of Canada’s largest companies. We’ve carefully compiled the key information investors need for every major public corporation in the country, and for the top 100 private companies too.
We know some investors will jump right in, looking for exciting new stocks. But others may feel a little overwhelmed by the sheer quantity of the data we provide in the tables that follow. Last year we relaunched the Top 1000 with a new proprietary Megastar stock rating system that crunches the numbers for you, so you can quickly home in on the best buys. Our system couldn’t be any simpler: The more stars a stock gets, the more appealing it is.
This sophisticated custom stock rating system is based on years of studies and historical data. Still, when we launched the Megastar system last year, we didn’t know exactly how well it would perform. Now the grades are in, and we’re pleased to announce that the system looks like a winner.
Last year, just 20 stocks out of the 1,000 achieved a full five-star ranking and made it onto the Megastar list. If you had purchased all 20, dividing your portfolio evenly among them, you would have enjoyed a stunning 16.2% return. By way of comparison, the market trailed behind with gains of only 2.6% over the same period, as measured by the S&P/TSX Composite Total Return Index.
Roughly two-thirds of last year’s crop of 20 Megastar stocks outperformed the market. The top gainer was Air Canada (AC), which shot up 68%. Canfor (CFP) was close behind, with a gain of 64%. West Fraser Timber (WFT) posted a 57% return, while Ski-Doo and all-terrain vehicle maker BRP (DOO) raced ahead with a 43% return. But it wasn’t all roses. The biggest laggard was Celestica (CLS), which gave up 27%. Just Energy (JE) was a close second. It powered down 24%. (All of the return figures mentioned here include reinvested dividends and span the period between May 12, 2017, and March 9, 2018. They do not include index fund fees, commissions, taxes or other trading frictions.)
On the whole, our approach is showing great promise, as it should. After all, the Megastar system merges two proven schools of investing. Value investing techniques are employed to zero in on profitable companies that trade at low prices relative to their fundamentals. These techniques are enhanced by trend-following methods used by momentum investors, who favour recent winners. Both are buttressed by measures of quality in an effort to steer clear of overly fragile businesses.
The Megastar system has nothing to do with our intuition about a given stock: It’s based entirely on the data. That means the number of stars a stock gets does not reflect the character of a company or its management or employees. It is entirely possible for the stock of an outstanding company to get a low rating when it trades at a very high price. Similarly, a low price might turn a less-than-wonderful business into an attractive investment.
Overall, we believe our system offers a rational and objective take on the largest stocks in Canada, and we hope you’ll enjoy this year’s Top 1000. Below we explain the system behind it and how we go about awarding the stars. If you’re anxious to get going, you can also jump right to our new crop of 20 buys in the “Megastar stocks 2018” list to the right.
1/ Bargain hunting
We love to look at the bottom line, so our search for bargain stocks starts with each company’s price-to-earnings ratio. We favour profitable firms trading at low prices. It’s a classic value investing approach that has a long pedigree.
Legendary investor and author James O’Shaughnessy studied it for the fourth edition of his influential book What Works on Wall Street. He reported that U.S. stocks with the lowest 10% of price-to-earnings ratios gained an average of 16.3% annually from the start of 1964 through to the end of 2009. By way of comparison, the average stock gained 11.2% annually over the same period.
But we don’t stop our search for value with just one ratio, because we’re also keen on stocks trading at low prices in comparison to their revenues. We shy away from companies that have yet to generate revenues and those that trade at very high price-to-revenue ratios.
We also take into consideration a firm’s cash flow by seeking out those with low price-to-cash-flow ratios. After all, it’s reassuring to see a company’s earnings translate into cold, hard cash.
Speaking of cash, we appreciate firms that pay generous dividend yields because we like to be compensated for taking on the risk of stock ownership. In addition, we approve of firms that reduce their share counts by buying back stock at reasonable prices. We combine both factors in an effort to figure out how much money a firm is returning to shareholders.
2/ Building momentum
Momentum investors love to buy stocks on the upswing, with the expectation they’ll continue to climb. Conversely, stocks on the decline have an unfortunate tendency of continuing to slide, at least in the short term.
While it might seem overly simplistic, buying based on momentum has been profitable in nearly every stock market in the world for decades, and it has worked well when applied to many other asset classes. Momentum has all the hallmarks of being a core feature of capital markets.
For instance, O’Shaughnessy reports that the 10% of U.S. stocks that performed the best over the prior six months went on to generate average annual returns of 14.1%, based on data from the start of 1927 through to the end of 2009. The average stock climbed at an annual rate of just 10.5% over the same period.
We take a blended approach when it comes to momentum and combine the results from several different periods. We favour stocks that have performed well, in comparison to their peers, over the past three, six, nine and 12 months. With a little luck, they will continue to do well over the next several months.
3/ Considering quality
The market does a reasonably good job of pricing in many of the outward signs of quality. It’s a big reason our approach to quality aims mainly to reduce risk rather than to enhance reward.
To start, we appreciate companies with solid returns on equity that have managed to deploy their capital wisely. It is also useful to look for a pattern of growth and to seek out firms that have grown their earnings-per-share at a reasonable rate over the past year. On the other hand, caution should be taken with firms that industry analysts believe will have negative earnings over the next 12 months.
The last quality indicator is a technical one. Highly volatile stocks are penalized, while firms with steadier return patterns are given a boost. The idea is to avoid stocks that act like lottery tickets, because they often fail to compensate investors for the risks they involve.
4/ Getting to the top
The Top 1000 follows a wide variety of companies, from the very large to the very small. The problem is, our star system runs into trouble when trying to deal with all of them in a fair way. For instance, penny stocks can experience large price swings that may cause difficulty for momentum-based approaches. Similarly, junior resource firms that have yet to earn a penny in profit don’t stand a chance of passing the value test.
We use several factors to deal with such cases. We start by grading only the largest 250 stocks on the TSX by revenue—the remaining 750 stocks in the Top 1000 don’t make the cut. Stocks are also set aside when they have less than a year’s worth of trading history or have traded for less than $2 per share over the same period. We exclude stocks with very high price-to-sales ratios, those with tiny market capitalizations and those subject to takeover offers. But we hope many of them will be up for five-star consideration next year.
5/ The Megastar stocks
You might be wondering how any stock can pass all of our tests, but we focus on how well they do in comparison to their peers. Only the top 20 stocks, as ranked using our criteria, are eligible for a five-star rating. They can be found in “Megastar stocks 2018” to the left, along with a little background on each company. (When calculating performance, we assume that investors sell all of the prior year’s picks when a new Megastar list is selected, and that they split their portfolios evenly among each of the new Megastar stocks.)
Detailed data for all of our Top 1000 stocks, including the star ratings out of five for the largest 250 companies by revenue, can be found online at tgam.ca/top1000. We have also reprinted detailed data for the largest 150 stocks by revenue in the magazine. (We couldn’t include all 1,000 due to space constraints, but subscribers have access to the online listing.)
The Top 1000 represents a great starting point for further research. But you should improve your understanding of each company by reading up on it and its industry. Get up to speed on any recent developments. Read the firm’s latest press releases and regulatory filings.
Before diving into the market, it is important to be mindful of the built-in limitations of quantitative methods like ours, because less tangible factors can also be important when investing. For instance, legal battles or the quality of a company’s culture and management can help, or hobble, a business.
Look up the facts and figures that mean the most to you. After all, the purpose of our star system is to help guide you through a constellation of data to discover the stocks that deserve a spot in your portfolio.
Air Canada (AC) returns to our Megastar list this year, after a stellar run as the top-performing stock on last year’s list, with a 68% return. The company runs the largest airline in Canada from its headquarters in Montreal and flies customers to more than 200 destinations on six continents. Even airline skeptic Warren Buffett recently had a change of heart and was spotted buying a basket of U.S. airline stocks. With luck, Air Canada will continue to be a good pick for investors.
BRP (DOO) makes recreational vehicles, including snowmobiles, watercraft and off-road vehicles. The company, based in Valcourt, Quebec, gained 43% since it joined the Megastar list last year. BRP has been returning money to shareholders by buying back stock. It cut its share count by a whopping 8.1% over the past 12 months.
Canfor (CFP) climbed 64% since it was inducted into the Megastar list last year. It is headquartered in Vancouver, along with its subsidiary, Canfor Pulp Products (see below). Canfor produces lumber and value-added finishing products, while its subsidiary produces pulp and paper products. Both are relative bargains at nine times earnings.
Canfor Pulp Products (CFX) is a smaller subsidiary of Canfor. As a returning Megastar, it has already delivered a 42% return.
Cascades (CAS) makes packaging and tissue products composed mainly of recycled fibres. Unfortunately, its stock gave up 2% since its debut as a Megastar last year. The firm is based in Kingsey Falls, Quebec, and trades at just three times earnings, largely due to the sale of its stake in Boralex (BLX) last summer. Cascades trades at a modest 11 times forward earnings based on industry analyst estimates for the next four quarters.
Interfor (IFP), formerly known as International Forest Products, gained 30% since it joined the list last year and makes its home in Vancouver. It produces lumber and related products at five mills in B.C. and 13 in the U.S. The firm sells almost three-quarters of its lumber stateside, where the housing market is picking up. It is also largely insulated from trade disruptions, because approximately two-thirds of its production is in the U.S.
Linamar (LNR), an auto-parts maker based in Guelph, Ontario, grew its revenues by 15% this quarter compared with the same quarter last year. Its stock price has zoomed up 18% since we highlighted it last year. It’s a nice move for a company that trades at nine times earnings and six times cash flow.
Magna International (MG), a large auto-parts maker based in Aurora, Ontario, gained 14% since becoming a Megastar last year. It now trades at nine times earnings and six times cash flow. The firm has been buying back stock and managed to reduce its share count by a hefty 6.3% over the past 12 months.
Martinrea International (MRE) is yet another auto-parts firm, and it’s the smallest of the bunch based on revenue. But it has fared the best since last year, with a gain of 31%. The company makes its home in Vaughan, Ontario, and trades at nine times earnings and five times cash flow.
Norbord (OSB) primarily makes oriented strand board (similar to particleboard) and runs 18 mills across Canada, the U.S. and Europe. The Toronto-based firm built up a 20% return since last time and hiked its quarterly dividend from 10¢ per share to 60¢ per share. As a result, Norbord provides an indicated yield of 5.4%. But income seekers should be aware that it has a variable dividend policy and its payments to investors depend on business conditions.
West Fraser Timber (WFT) is another returnee from last year’s list and it posted a 57% gain. The Vancouver-based firm is the largest lumber producer in North America. Approximately 42% of its capacity is located in the southern U.S., with the remainder split between B.C. and Alberta. While recent trade disputes haven’t helped the share price, they didn’t stop the firm from boosting its quarterly dividend from 7¢ per share to 15¢ per share, which represents a vote of confidence.
Canaccord Genuity (CF) is a new addition to the Megastar list. It focuses on wealth management and capital markets (think investment banking). The Vancouver-based company’s stock saw some big swings over the past year. It hit a 52-week low near $4 per share but recently moved above $7 per share, and hopefully it will continue to trade higher.
Canadian Tire (CTC.A), based in Toronto, runs more than just its namesake general stores. It also owns PartSource (auto parts), FGL Sports (sporting goods), Mark’s (work apparel), CT REIT (CTR.UN) and a financial services division. The company has a pleasing habit of growing its dividend and returning money to shareholders. It reduced its class-A share count by 5.1% over the past 12 months.
First National Financial (FN) offers residential and commercial mortgages to Canadians. The Toronto-based firm is the nation’s largest non-bank lender. It pays a hefty indicated dividend yield of 6.8% and trades at eight times earnings, which is attractive. However, its stock might react poorly in the event of a real estate market collapse.
Methanex (MX), based in Vancouver, makes and supplies methanol to major markets in North America, Asia, Europe and South America. Management says the company has been trading below its replacement cost, which helps explain why the company reduced its share count by 6.7% over the past 12 months.
Russel Metals (RUS) is in the metals distribution business and makes its home in Mississauga. Some 30% of the firm’s revenues came from the U.S. in 2017, while the remaining 70% came from Canada. Income investors will appreciate its 5.0% indicated dividend yield and recent dividend growth record. Mind you, Russel’s business tends to be cyclical, and it was forced to cut its dividend in 2009.
Stuart Olson (SOX), formerly known as Churchill Corp., provides general contracting, construction management and related services. The Calgary-based company fell on hard times in recent years but appears to be recovering. The relatively small stock (with a market capitalization near $200 million) pays a generous indicated dividend yield of 6.5%.
Teck Resources (TECK.B) is a diversified mining company based in Vancouver that operates in Canada, the U.S., Chile and Peru. The firm’s stock has had an unfortunate habit of frightening shareholders over the past decade with steep price declines followed by sharp snap-backs. For instance, its stock plunged below $4 per share in 2008, bounced back and then made a return trip to similar depths in 2016, after it lost $2.5 billion in 2015. But Teck has returned to health and will hopefully continue to move higher.
Transat A.T. (TRZ) is a holiday travel company that offers Canadians vacation packages to 26 countries in the Americas, Europe and the Middle East. The Montreal-based firm is recovering from a bad year in fiscal 2016, when it lost $42 million. But it recently returned to profitability and trades at three times earnings, thanks largely to asset sales. It also trades at 12 times forward earnings, based on industry analyst estimates for the next four quarters.
Wajax (WJX) is an industrial products distributor based in Mississauga. Hardship in western Canada helped push the company to an $11-million loss in 2015 and a dividend cut. But Wajax returned to profitability, and its stock has started to climb slowly back toward its 2012 highs, near $50 per share.
Norm Rothery, PhD, CFA, is the founder of StingyInvestor.com, which has been catering to investors since 1995. He obtained a PhD in atomic physics from York University before following his passion for investing to work for investment counsel firms Dan Hallett & Associates and Fundmonitor.com. His quantitative methods and portfolios have appeared in numerous magazines for almost two decades. His longest-running system got its start in December 2000 and, as of its last update, has gained an average of 15.6% per year over 17 years. Another value-oriented method sprang to life in 2001 and has yielded an average return of 15.8% per year so far. Rothery currently holds shares of Magna and Wajax, as well as other less highly rated Canadian stocks.