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(Photos.com)

NUMBER CRUNCHER

The magic mix: profitable and cheap stocks Add to ...

What are we looking for?

Profitable companies that are also cheap.

In today’s uncertain markets, investors should favour companies that are delivering earnings or free cash flow and that are inexpensive.

Joel Greenblatt, founder of Grantham Capital, a U.S. investment partnership, wrote The Little Book that Still Beats the Market. His Magic Formula uses two factors to find stocks that are profitable and cheap.

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The first is return on capital, which is defined as pretax operating earnings divided by the total of net working capital and net fixed assets. The second is earnings yield, which is defined as pretax operating earnings divided by enterprise value, the total of the market value of equity and net debt.

More about today’s screen

In creating today’s offering, I filtered the CPMS database of Canadian companies for large firms using Mr. Greenblatt’s formula.

In addition to strong return on capital and high earnings yield, I looked for firms with:

  • a market cap greater than $400-million;
  • trade greater than $10-million per month.

Back testing – based on up to 25 stocks from January, 2011, to March, 2012, using the CPMS Canadian database – showed the Magic Formula significantly outperformed the S&P/TSXcomposite index (20.3 per cent for the portfolio versus 7.6 per cent for the S&P/TSX), but there was significant year-to-year variation. These profitable and cheap stocks outperformed during bull markets, not during market corrections.

Mr. Greenblatt notes: “You must be committed to this process for a minimum of three to five years … [to give] the Magic Formula a chance to work.”

What did we find?

Many of the companies had strong earnings growth over the past 12 months, but analysts are forecasting a significant decline in earnings for fiscal 2012 for most of the companies. MacDonald Dettwiler, Pacific Rubiales Energy and TransGlobe Energy stand out as their earnings are forecast to grow over 24 per cent in 2012.

None of the companies are forecast to have improved earnings in 2012 versus their past 12 months’ earnings growth. However, most of the companies have an above-average trailing free cash flow yield.

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Canadian stocks with strong return on capital and high earnings yield

Company Symbol Price $ (June 18) Market cap. ($ mil.)
Nevsun Resources Ltd. NSU-T 3.99 799.6
Canyon Services Group FRC-T 9.96 608.6
Pacific Rubiales Enrgy PRE-T 23.12 6810.0
Calfrac Well Services CFW-T 23.17 1027.8
TransGlobe Energy Corp TGL-T 9.59 700.6
Trican Well Service Ltd TCW-T 12.19 1791.7
Gran Tierra Energy Inc GTE-T 4.89 1390.0
Total Energy Serv. Inc. TOT-T 14.41 451.3
MacDonald, Dettwiler MDA-T 43.69 1390.5
Celestica Inc. CLS-T 7.89 1520.1

Source: Morningstar

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