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The Megastar system has what it takes to succeed over the long term because it combines two proven schools of investing: value and momentum

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The Top 1000 is the most authoritative ranking of Canada’s largest companies. It reveals key information on every major public corporation in the land, and our Megastar system highlights firms with the best value and momentum characteristics. The more appealing a firm’s stock is, the more stars it gets.

Our Megastar team is made up of the 20 stocks that achieve a full five-star ranking each year. The team's first outing, from 2017 to 2018, was quite profitable. If you had purchased all 20 five-star stocks, dividing your portfolio evenly among them, and held them for one year, you would have gained 16.2%. By way of comparison, the market gained 2.6% over the same period as measured by the S&P/ TSX Composite Total Return index. (All of the return figures mentioned herein include reinvested dividends. They do not, however, include index-fund fees, commissions, taxes or other trading frictions.)

But as every stock picker knows, setbacks happen. And unfortunately, the tide turned last year, with the Megastar team losing an average of 16.5% since March 2018. The S&P/ TSX Composite Total Return index, meanwhile, climbed 5.9% over the same period. It was a disappointing year for the Megastars.

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That's a painful loss, but successful investors take the bad with the good. For instance, I recently highlighted a simple system that follows stocks with the lowest price-to-earnings ratios in the S&P/TSX 60 Index each year. It walloped the market over the long term, with average annual gains of 16.7% from the end of 2002 to the end of 2018. But it trailed the index in five of the 16 annual periods, often by a substantial margin. It also produced some unpleasant downturns along the way, including a 43% loss in 2008.

We do believe the Megastar system has what it takes to succeed over the long term because it combines two proven schools of investing. It starts with value investing principles, which narrow in on profitable companies that trade at low prices relative to their fundamentals. Those principles are enhanced by trend-following techniques used by momentum investors who favour recent winners. Both approaches are strengthened by measures of quality that help investors avoid fragile businesses.

The Megastar system is based entirely on the numbers and has nothing to do with our intuitions about a stock or the less tangible aspects of its business. As a result, the number of stars a stock gets does not reflect the character of a company, its management or employees. It is entirely possible for the stock of an outstanding company to get a low rating when it is in a downtrend. Similarly, strong momentum can make a slightly less than wonderful business into an attractive investment.

We think our system offers a rational and objective take on the largest stocks in Canada and hope you’ll enjoy this year’s Top 1000. Below, we explain the system in more detail and how we go about awarding the stars. If you’re anxious to see the results, check out the new list of top 20 stocks in the “Megastar stocks 2019” box starting right here on this page.

FINDING VALUE

We start our analysis with a company’s bottom line by searching for bargain stocks that have low price-to-earnings ratios. It’s a classic value investing approach that leads to profitable firms trading at relatively low prices.

Legendary investor and author James O'Shaughnessy studied the ratio for the fourth edition of his influential book What Works on Wall Street. He reported that U.S. stocks with the lowest 10% of price-to-earnings ratios gained an average of 16.3% annually from the start of 1964 through to the end of 2009. By way of comparison, the average stock gained 11.2% annually over the same period.

We don't stop at considering just one ratio, however. We also like stocks trading at low prices in comparison to their revenues. On the other hand, we avoid companies that have yet to generate revenue and those that trade at very high price-to-revenue ratios.

We also take into consideration a firm's cash flow and look for those with low priceto-cash-flow ratios. After all, it's reassuring to see a company's earnings translate into cold, hard cash.

Speaking of cash, we appreciate firms that pay generous dividend yields because we like to be compensated for taking on the risk of stock ownership. In addition, we gravitate to firms that reduce their share counts by buying back stock. We add up the value of these transactions in an effort to gauge how much money a firm is returning to shareholders.

MOVING WITH MOMENTUM

Momentum investors love to buy stocks on the upswing because they have a habit of continuing to climb. Conversely, stocks on the decline tend to persist in sliding, at least in the short term.

While it might seem overly simplistic, buying based on momentum has been profitable in nearly every stock market in the world for decades. It has also worked well when applied to many other asset classes.

For instance, O'Shaughnessy reports that the 10% of U.S. stocks that performed the best over the prior six months went on to generate average annual returns of 14.1%, based on data from the start of 1927 through to the end of 2009. The average stock climbed at an annual rate of just 10.5% over the same period.

We take a blended approach when it comes to momentum and combine the results from several periods. We favour stocks that have performed well, compared to their peers, over the past three, six, nine and 12 months. With a little luck, they'll continue to do well in the next several months.

CONSIDERING QUALITY

The market does a reasonably good job of pricing in many of the outward signs of quality. That’s why our approach aims to reduce risk rather than enhance reward.

To start, we appreciate companies with solid returns on equity. It's also useful to look for a pattern of growth and to seek out firms that have grown their earnings-per-share at a reasonable rate over the past year. On the other hand, investors should be cautious with firms that industry analysts believe will have negative earnings over the next 12 months.

The final quality indicator is a technical one. Highly volatile stocks are penalized, while firms with steadier return patterns are given a boost. The idea is to avoid stocks that act like lottery tickets, because they often fail to compensate investors for the risks involved.

GETTING TO THE TOP

The Top 1000 follows a wide variety of companies, from the very large to the very small. The problem is, our star system runs into trouble dealing with all of them in a fair way. For instance, penny stocks can experience large price swings that might cause trouble for momentum-based approaches. Similarly, junior resource firms that have yet to earn a cent in profit don’t stand a chance of passing the value test.

We use several factors to deal with such cases. We start by grading only the largest 250 stocks by revenue on the TSX—the remaining 750 don’t make the cut. Stocks are also set aside when they have less than a year’s worth of trading history or have traded for under $2 per share over the same period. We exclude stocks with very high price-to-sales ratios, those with tiny market capitalizations and those subject to takeover offers. But we hope many of them will be up for five-star consideration next year.

THE MEGASTAR STOCKS

While you might wonder how any stock can pass all our tests, we focus on how well they do in comparison to their peers. It’s a contest in which the best candidates take home the top prize. Our star system gives a full five stars to only 20 of the largest 250 stocks. They can be found in the “Megastar stocks" sidebar below.

Detailed data for all our Top 1000 stocks, including the star ratings out of five for the largest 250 companies by revenue, can be found here.

While the Top 1000 represents a great starting point for further research, you should improve your understanding of each company by studying it and its industry. Get up to speed on any recent developments, and read the latest press releases and regulatory filings.

Before dashing off to the market, be mindful of the built-in limitations of quantitative methods like ours, because less tangible factors can also be important when investing. For instance, the quality of a company’s culture and management can help, or hinder, a business.

But be sure to look up the facts and figures that mean the most to you. After all, the purpose of our star system is to guide you through the market to stocks that might deserve a spot in your portfolio.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com, which has been catering to investors since 1995. He obtained a PhD in atomic physics from York University before following his passion for investing to work for investment counsel firms Dan Hallett & Associates and Fundmonitor.com. His quantitative methods and portfolios have appeared in numerous magazines for almost two decades. His U.S. value method sprang to life in 2001 and has gained an average of 16.2% per year so far. A Canadian growth-at-a-reasonable-price method outperformed the market by an average of 8.2 percentage points per year since it started in 2004. Rothery currently holds shares of Magna, Martinrea, Power Corp., Power Financial and Wajax in his personal account, as well as other less highly rated Canadian stocks.


Megastar stocks

Air Canada (AC) returns to our Megastar list for the third year in a row. The stock gained 22% over the past year and a total of 105% since it first became a Megastar stock. Air Canada runs the largest airline in the land from its headquarters in Montreal and flies customers to more than 220 destinations on six continents. Hopefully the firm’s strong momentum will continue well into 2020.

Capital Power (CPX) is a power producer based in Edmonton that owns 5,100 megawatts of power generation capacity at 25 facilities in North America. The firm trades at seven times cash flow and pays a hefty indicated dividend yield of 5.8%. Income investors will cheer management’s plans to boost the dividend by 7% per year for the next three years.

Cogeco Inc. (CGO) is based in Montreal and controls cable company Cogeco Communications (CCA) via ownership of 32% of its equity shares. The parent also has a small media arm that operates 22 radio stations in Quebec and one in Ontario. Practically speaking, investors should hold either Cogeco or Cogeco Communications. At this point, the parent company trades at 10 times earnings and offers a slightly better value.

Cogeco Communications (CCA) is a cable company based in Montreal that conducts business in Quebec, Ontario and in 11 states along the east coast of the U.S. The firm trades at 12 times earnings and pays a 2.5% indicated dividend yield.

Corus Entertainment (CJR.B) is a Toronto-based media company with 44 specialty TV channels, 15 TV stations and 39 radio stations. It trades at 3.5 times its fiscal 2018 free cash flow and pays a 4.1% dividend yield. The Shaw family controls both Corus and Shaw Communications (SJR.B).

Empire Co. (EMP.A) is best known as a food retailer that hails from Stellarton, Nova Scotia. Its Sobeys subsidiary operates more than 1,500 food stores and more than 350 retail fuel locations across Canada. Empire also owns a 41.5% interest in Crombie REIT (CRR.UN), along with other real estate investments and partnerships. While Empire hit a rough patch in 2016, it has recovered nicely and gained 23% over the past 12 months.

Enerflex (EFX) supplies natural gas compression, gas processing, refrigeration systems and electric power generation equipment. While the firm makes its home in Calgary, in 2018, 58% of its revenues came from the U.S., 18% from Canada and the remainder from abroad. Its stock gained 22% over the past year and is nearing a 10-year high.

Equitable Group (EQB) provides financial services across Canada through Equitable Bank. The Torontobased firm trades at 91% of book value and seven times earnings. While it pays a relatively modest indicated dividend yield of 1.8%, it has increased its dividend payments frequently over the past eight years.

Exchange Income (EIF) is an acquisitive aerospacefocused conglomerate based in Winnipeg. While the firm has been subject to pressure from short sellers, industry analysts are keen on its prospects. It currently pays an exceptionally large dividend yield of 6.7%, which is just covered by its earnings yield of 6.9%.

Gibson Energy (GEI) is an integrated midstream company based in Calgary. It has two oil terminals in Alberta and nearly 12 million barrels of storage capacity. While the company lost money in 2015 and 2016, it has recovered since then, with its stock jumping 50% over the past 12 months. Despite the recent advance, Gibson pays a hefty dividend yield of 5.9%.

Magna International (MG) is another company to make the Megastar list for three years running. The auto-parts maker based in Aurora, Ontario, has climbed 14% since it was added to the team. Magna grew its sales by 11% over the last four quarters and its earnings by 5% while trading at just eight times earnings. It also managed to reduce its share count by 9% over the same period.

Martinrea International (MRE) is another Megastar alumnus, with its third five-star award. While the auto-parts firm’s stock has fallen by 15% since last year, it climbed by 31% in its prior outing. Martinrea makes its home in Vaughan, Ontario, and trades at six times earnings and four times cash flow.

Morguard Corp. (MRC) is a real estate investment company based in Mississauga. Its publicly listed subsidiaries are Morguard REIT (MRT.UN), Morguard North American Residential REIT (MRG.UN) and Temple Hotels (TPH). The firm and its subsidiaries own 214 properties across North America. Morguard Corp. trades at seven times earnings and has reduced its share count by 5% from last year.

The North West Co. (NWC) is a retailer in underserved and remote communities in Northern Canada, Western Canada, Alaska, the South Pacific islands and the Caribbean. The Winnipeg-based firm sold almost $2-billion worth of goods over the past 12 months. It trades at 0.8 times sales and pays a 3.9% dividend yield.

Parex Resources (PXT) makes its home in Calgary, but explores and produces oil in Colombia. The firm grew its revenues by 66% to $1.3 billion in 2018, while generating profits of $522 million. It trades at six times earnings, four times cash flow and has a strong balance sheet with no longterm debt.

Power Corp. of Canada (POW), the Montreal-based financial conglomerate, has a 65.5% interest in wealth management firm Power Financial (PWF), which itself has a 67.7% interest in insurer Great-West Lifeco (GWO). All three firms made it into this year’s Megastar list. Power Corp. also has a sprawling list of international operations. It offers a dividend yield of 5.3% and recently announced a hefty share repurchase program, which helped lift its stock.

Power Financial (PWF) is the main arm of Power Corp. The Montreal-based firm owns 67.7% of Great-West Lifeco and 61.4% of money manager IGM Financial (IGM). Power Financial pays a 5.8% indicated dividend yield, trades at 11 times earnings and also recently announced a big share repurchase plan.

Great-West Lifeco (GWO) of Winnipeg is the health and life insurance arm of Power Financial (PWF). It trades at 10 times earnings, pays a 5.3% indicated dividend yield and has a big share buyback plan in the works.

Quebecor Inc. (QBR.B) is a cable and media company based in Montreal. Its telecom operations generated the vast majority of its revenues and profits over the past year. It trades at five times cash flow and sports strong momentum, with one-year gains of 29%.

Rogers Sugar (RSI) refines and sells a range of sugars, and it recently added maple syrup to its lineup. The Vancouver-based firm is the smallest Megastar this year, with revenues of $807 million and a market cap of $639 million. But it offers income investors a sweet dividend yield of 5.9%.

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