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Number Cruncher

Investor alert: Flagging those firms you'd like to avoid Add to ...

What are we looking for?

Danger signs. Alarm bells. Flashing red lights. And a way out.

Today, we're going to take a look at how to crunch the numbers to identify things you usually want to avoid owning.

For more than 20 years, CPMS, an equity research and portfolio analysis firm owned by Morningstar Canada, has been running a screen to identify the stocks with the most troubling combination of fundamentals in the Canadian market. The 30 worst stocks out there, according to the criteria it looks at, comprise the CPMS Dangerous Model Portfolio.

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How does the screen work?

There are six indicators CPMS uses to determine how "dangerous" a stock is:

- earnings growth over the trailing four quarters;

- price-to-earnings ratio, based on the consensus earnings forecast for the next 12 months;

- earnings surprise - the percentage by which the stock fell short of the consensus earnings estimates for the most recent quarter;

- percentage by which earnings estimates for the current year (or, once we've entered the fourth quarter, for the upcoming year) have changed over the past three months;

- the ratio of debt to equity;

- the ratio of trailing-four-quarter cash flow-to-debt.

Stocks are given a percentile rank within each category, with a score of 100 indicating that a stock is the single worst stock in a given category.

The rankings subsequently feed into a weighted scoring system that penalizes a company more for weaknesses in certain areas rather than others. CPMS does not disclose the weightings that it applies to each metric.

CPMS runs all 655 Canadian stocks in its database through this screen. While the final portfolio actually comprises 30 names, CPMS has provided 20 names here - and they are the worst of the worst.

What did we find?

By design, this is supposed to be a list of "stocks to avoid," according to Jamie Hynes, senior account manager with CPMS.

Nonetheless, it's a list that's behaved badly of late in an unexpected way. In 2009, Mr. Hynes noted with some puzzlement, it was actually up 85 per cent. Going all the way back to December, 1985, the model's annualized return is around minus 8 per cent and even with last year's pop, the three-year return is minus 18 per cent. A case of every dog having its day perhaps?

This year, things appear to be more moving back to the mean.

In May, the Dangerous portfolio underperformed the TSX by 4.7 per cent and is also down year-to-date.

This is actually the third time Number Cruncher has taken a look at this particular list and one thing that stands out is a three-peat by Ivanhoe Mines Ltd. in cracking our version of the most-dangerous list. It's actually the name that's had the longest run in the Dangerous Model Portfolio, having been added in October, 2006. Over that time it is actually up 114 per cent and so not typical of the names on the list - chalk up its counter-trend presence to it not trading on fundamentals and on expectations and the outlook for commodity prices.

The second longest denizen on the list is more typical of the names here. Kingsway Financial is down about 80 per cent since it was added in May, 2008.

What to do if a name you own is on this list? Take a close look at why you own it, do some research, and decide if it's still a name you want in your portfolio.

In the know

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