Toronto’s financial district at the corner of Bay and Adelaide streets.Gloria Nieto/The Globe and Mail
Think about how you'd go about ranking all of Canada's largest stocks for their investment appeal. It's a daunting task. I've been doing it, in various publications, for more than a decade. While there have been a few bumps along the way, the overall results have been more than satisfactory.
But the pressure was really on when I was asked to develop a ranking system for the Report on Business magazine's Top 1000 this year.
The feature provides a plethora of useful facts and figures on the largest stocks in Canada. It now also includes a star rating to highlight those with the best prospects, which earn a full five out of five possible stars.
For subscribers: The Top 1000: We rate every major Canadian stock in this exclusive ranking
The new system is based entirely on the numbers. It puts fundamental and technical data through a series of tests to evaluate each stock. A core part of the algorithm relies on value-investing principles and techniques of the sort the pros use.
I'd like to give you a sense of the depth and long history of some of the studies that back up the value approach.
The great teacher, and money manager, Benjamin Graham wrote about stock-picking techniques way back in the 1973 edition of his book The Intelligent Investor.
In it, he includes a recipe for defensive investors, which I tweaked to good effect just after the turn of the century. Stocks selected by the method produced a compound annual return of 15.8 per cent over the following 16 years. By way of comparison, the market grew at an annual rate of 4.8 per cent over the same period. It's a big reason why I'm a fan of numerical techniques.
Even simple methods, such as picking stocks with low price-to-earnings ratios (P/E), have worked well for a very long time. Mr. Graham highlighted one study in which 10 stocks with the lowest P/Es in the Dow Jones industrial average were purchased each year. The low-P/E portfolio gained 569 per cent from 1936 to 1962 and outperformed the 30 stocks in the average which gained 340 per cent over the same period.
More recent studies confirm the advantage provided by low-P/E stocks.
James O'Shaughnessy looked at the ratio in the fourth edition of his influential book What Works on Wall Street. He reported that U.S. stocks with the lowest 10 per cent of P/E ratios gained 16.25 per cent annually from the start of 1964 through to the end of 2009. The average stock gained 11.22 per cent annually over the same period.
These, and other, studies are a big reason why classic value-investing ratios are included in the new star system.
More specifically, the system favours stocks with low multiples of sales, earnings and cash flow. All of which have worked well for investors over the long term.
But the system doesn't just use value characteristics. Momentum is also added to the mix because it has a similarly long history of success.
The idea here is to hitch a ride with stocks that have climbed a great deal over the past few months with the view that they'll likely continue to advance. In addition, each stock was measured against quality factors in an effort to reduce risk by weeding out shaky situations.
The star system is laid out in detail in this month's magazine and you can read all about it online. But before you do I'd like to share with you a couple of the system's top picks, which I happen to own personally.
- Insurance-based conglomerate E-L Financial Corp. Ltd. (ELF) is one of the five-star stocks this year. At $862 a share, it trades near the high-end of its 52-week range, sports a bargain P/E under 10 and goes for just 71 per cent of its net asset value. On the downside, its shares are relatively illiquid.
- Auto-parts maker Magna International Inc. (MG) is also in the five-star spotlight. It trades at eight times earnings and is just off its highs for the year. With a little luck, the economy will continue to motor higher and take Magna with it.
The full ROB Top 1000 feature, including a wealth of data on the 1000-largest companies in Canada and details about the star system, can be seen at tgam.ca/top1000.