Number Cruncher

Energy firms show their domination

From Thursday's Globe and Mail

WHAT ARE WE LOOKING FOR?

Yesterday, we screened the S&P/TSX composite index for stocks that best emulated the strategies of hedge fund manager and investing author Joel Greenblatt - one of the dozen market gurus whose approach to stock picking is tracked by U.S. market-data-analysis website Validea.com.

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The screen generated some interesting names, the bulk of which were income trusts. Some readers felt this was problematic, since trusts are different animals than common-share equities.

So, we decided to do a similar analysis, excluding the trusts, to create a list of Greenblatt-friendly Canadian common stocks.

GREENBLATT SCREEN FOR TSX COMMON STOCKS

Mr. Greenblatt described his "magic formula" for stock picking in his 2005 bestseller, The Little Book That Beats the Market. Back-tests of the formula showed average annual returns of 30.8 per cent from 1988 through 2004, compared with the S&P 500's 12.4-per-cent average. The strategy has also proven the most successful over the past year among the U.S. model portfolios Validea maintains to mimic the strategies of 12 well-known market gurus, including legends Warren Buffett and Benjamin Graham.

Mr. Greenblatt's approach focuses on two criteria: Earnings yield (annual earnings per share as a percentage of stock price, essentially the price-to-earnings ratio flipped on its head), and return on capital. He ranks all the stocks he tracks on each of these criteria, adds the two rankings together, and the stock with the lowest total is his highest-rated stock.

Income trusts are notoriously strong cash-flow generators, and since that contributes to return on capital, that could explain why so many trusts were near the top of yesterday's screen. However, the trust model is designed to pay much of that cash flow out in distributions to unitholders, a great model for income but not so good for growth.

But since that income is undeniably attractive in uncertain markets, we decided that a list that ignored the Greenblatt-friendly trusts might unfairly rob investors of substantial returns in the form of dividends. So, we modified the screen to eliminate any common stock that had a dividend yield of less than 2 per cent.

WHAT DID WE FIND?

The common-equity-only list still favours big energy names, led by Canada's largest energy company, EnCana Corp. Not only does it boast the best earnings yield and the second-best return on capital among stocks that meet the screen criteria, it also yields a solid 3.5-per-cent dividend.

WHAT DID WE FIND?

The common-equity-only list still favours big energy names, led by Canada's largest energy company, EnCana Corp. Not only does it boast the best earnings yield and the second-best return on capital among stocks that meet the screen criteria, it also yields a solid 3.5-per-cent dividend.