The key to finding gems among stocks in the volatile, fast-changing and occasionally hazardous Canadian media sector? Follow the cash, David McFadgen says.
“Over the last couple of years, we’ve been in a yield-hungry market,” said the 45-year-old analyst at Cormark Securities Inc., who has seen massive changes in the 16 years that he has been tracking media stocks in this country. “So I look a lot at free cash flow and the potential for dividend increases, because those have a meaningful impact on stock price movements.”
That focus has been working. Stock market analytics firm StarMine Corp. ranks Mr. McFadgen in first place out of eight Canadian media-sector analysts, based on the performance of his stock recommendations for the past 24 months. He was the top-ranked analyst for 2009 and for 2010. And he ranks a close second (to Credit Suisse’s Colin Moore) for the past 12 months.
Tim Gaumer, director of fundamental research at Thomson Reuters, applauded Mr. McFadgen’s consistent superior performance over multiple time frames – in an unpredictable few years that saw some wild ups and downs in the sector.
“The volatility in this sector has been a challenge for every analyst trying to follow these stocks,” he said. “All the analysts have had some difficulty with buy-rated stocks that went down a lot or lower-rated stocks that suddenly appreciated a lot.”
“Even though [Mr. McFadgen] has had his losers as well, overall he’s had the best relative outperformance over most of these [time] periods,” he said.
Data compiled by StarMine – a service owned by Thomson Reuters – show that Mr. McFadgen’s recommendations generated excess returns of 29.2 per cent above the overall Canadian media sector over the 24 months, well ahead of second-place Vince Valentini of TD Newcrest (22.3 per cent). For the past 12 months, his 8.6-per-cent excess return is just shy of Mr. Moore’s 8.8 per cent.
StarMine’s industry excess returns ratings use each analyst’s stock recommendations to create a “long-short” investing strategy – mimicking the effect of going long on stocks the analyst rates “buy” and shorting the stocks he or she rates “sell.” This way, the analyst gets credit for both “buy”-rated stocks whose returns exceed the overall industry benchmark, and “sell”-rated stocks whose returns underperform the benchmark. (Stocks rated “strong buy” or “strong sell” are awarded double credit; ratings of “hold” or “neutral” receive no score.)
Mr. McFadgen says his process for stock picking begins with “trying to understand the business – I build a detailed model.” Then he takes a closer look at a range of factors including the earnings expectations (and the potential to beat them), a few key valuation metrics on the stock (price-to-EBITDA, price-to-free-cash-flow and dividend yield), the health of the balance sheet, and the business’s exposure (positive or negative) to the evolution of digital media.
“It’s not a cookie-cutter approach,” said the Cormark Securities Inc. analyst. “Every company is unique.”
He stressed that growth is not a major concern for deciding whether to recommend a stock in this sector.
“Even though a company might not be growing a lot, if they’re going to be generating record free cash flow – and therefore their dividend is going to be cranking up – I’d recommend it,” he said.
He said Transcontinental Inc. , for example, “is not growing – but it’s going to be generating record free cash flow, and they raised the dividend three times in the past 18 months. That’s why I recommended it.”
His current top pick, Corus Entertainment Inc. , has a similar story in some respects. The company has record free cash flow, and earlier this month raised its dividend in advance of expectations.
The difference, Mr. McFadgen said, is on the growth side. “Corus has a number of growth initiatives on the way that I think could result in higher earnings,” he said.
On the flipside, he said companies facing a major shake-up from the advent of digital media can pose a danger. For example, he’s been a long-time bear on Yellow Media Inc. , whose stock has shed about two-thirds of its value this year.
“He did a great job of warning people off that one,” Mr. Gaumer said. “It has the signs of a perfect value trap.”
Mr. McFadgen believes cash flow and dividend potential will continue to be a key driver for media stocks over the next year, as prospects for growth in the group are generally slim.
“Growth is slowing, but free cash flow is accelerating. They all have really strong balance sheets, and they’re all raising dividends,” he said.
“The valuations are not high. A lot of these stocks are trading in the five-times EBITDA range, which if you go back historically over the past 15 years, is pretty low,” he said. “The companies are not expensive.
“What we need is a better capital market environment than what we have right now,” he said. “These stocks are also highly sensitive to the economy. If the economy picks up, the earnings will pick up and the multiples will expand.”
“I would focus on companies that have large exposure to television or Internet,” he said. “The challenges are going to be on the newspaper side and radio. If you have a company with large exposure to that, you’ve got to look at it differently.”