I have a quantitative bent and a fondness for screening stocks, so it may come as no surprise that Number Cruncher is one of my favourite Globe Investor features. But just one quibble: It's nearly always telling you what stocks to buy, not the ones to avoid.
So me being me, when I read the recent Number Cruncher on companies that had the best return on capital, versus what their capital cost them, I naturally said, "That's great – but which ones are the worst?"
So I contacted Inovestor, the Montreal company whose StockPointer database was the source for that particular column, and asked them to flip the idea on its head. Sure, it's great to know Dollarama has great returns, but which Canadian companies are the laggards?
Before we get to the answer, let's review the metrics. The Number Cruncher in question sought to identify Canadian companies with high economic performance (as well as growth and a stock price below historical valuations). StockPointer creates its Economic Performance Index by taking the companies' return on capital and dividing it by their cost of capital.
More specifically: For the return, StockPointer uses net operating profit after tax (or NOPAT). This profit measure is typically higher than net income, which includes interest costs, but is lower than EBITDA, which is an earnings measure that excludes depreciation and taxes. Calculating cost of capital – often called "weighted-average cost of capital," or WACC – is, I would say, even more of an art than a science. Companies don't disclose it, so analysts must combine the interest rates on company debt with an assumed cost of the equity a company issues. When a company's stock is more volatile, its cost of equity is higher under certain methods of calculation.
"Calculating the WACC of a company is definitely not an exact science; if you ask 10 different analysts to estimate a WACC, chances are they will all come up with similar, but different values," says Jean-Didier Lapointe, executive director at Inovestor. Yet "it remains very important for investors to be able to know what's the WACC of companies they invest in. It is the only way to know if the company really generates wealth for shareholders through its investments, meaning its return on invested capital is greater than their cost of capital."
In the universe of the 253 Canadian companies with a market capitalization of $1-billion or higher, StockPointer found 133 that had an EPI below 1.0 – which means the company's return over the past four quarters didn't cover its cost of capital. Of course, if you've been reading the Report on Business over the last four quarters, you can take a guess as to what the problem is – 90 of the companies come from the resources sectors, either energy or mining. That type of performance may be transitory, depending on how oil and gold do in the coming years.
To cut through that problem, however, we can look at a five-year average return on capital. This is where things get interesting. It shows investors likely don't have to worry about companies like Nevsun Resources Ltd., which has averaged a 23-per-cent return on capital by StockPointer's calculation.
Others, however, such as McEwen Mining Inc., MAG Silver Corp., Enerplus Corp. and NuVista Energy Ltd. – to take a sample of companies with double-digit, negative returns on capital over the last five years – have a consistent problem with profitability. Guyana Goldfields, Raging River Exploration and Finning, which appear in the accompanying table, are other less dramatic examples. Raging River and Finning have been profitable, on average, over the period – just not profitable enough to cover a high cost of capital.
Any company that's losing money isn't earning more than its cost of capital. But another interesting takeaway from the data is the wide range in the cost-of-capital numbers that establish the hurdle that must be cleared: Brookfield Renewable Partners LP, with its 4.9 per cent cost of capital, doesn't have to be terribly profitable to be in positive territory in the Economic Performance Index. (At a return of 4.5 per cent in the past four quarters, it was not, however.) Potash Corp. of Saskatchewan's 8 per cent WACC wasn't an issue in the past, as it's averaged a 12-per-cent return on capital in the last five years, but with the collapse in fertilizer prices, its return of 5.9 per cent over the last four quarters puts it on the loser list.
The WACC hurdle is far higher, however, for others. There are 61 companies on this list with cost of capital of 10 per cent or more, and a handful have costs of capital of 14 per cent or more. The aforementioned McEwen Mining and MAG Silver have costs of capital of around 15 per cent; by having such high losses, the spread between their negative returns and their cost of capital stretches to around 30 percentage points – a situation that seems nearly impossible to overcome.
In essence, companies who consistently fall far short of their cost of capital are the opposite of the wealth-creating economic performers our Number Cruncher found; they're wealth destroyers.