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What are we looking for?

Materials companies with low leverage and stable earnings.

The screen

At the end of the third quarter, roughly 11.5 per cent of the S&P/TSX composite total return index was weighted in the materials sector. Materials have historically been an area of caution for retail investors as the prices of stocks are tied heavily to fluctuating commodity prices, making it difficult to pick companies outside of the largest in the sector (with the idea that bigger is safer). This week, I used Morningstar CPMS to look a bit deeper into the sector, ranking the stocks based on the factors below. Today, there are 197 companies in this sector within the CPMS Canadian database.

  • Earnings variability (a proprietary metric that measures how stable earnings have been over time, lower figures preferred);
  • Five-year cash flow growth rate (on average, how much operating cash flows have grown each year over the past five years);
  • Cash flow to debt (we prefer companies with high cash flow relative to debt – that is, less leveraged);
  • Enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA), lower figures preferred;
  • Trailing return on equity, higher figures preferred.

To qualify, materials companies must have a market capitalization greater than $500-million.

More about Morningstar

Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutionl clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.

What we found

I used Morningstar CPMS to back-test this strategy from November, 2001, to October, 2017. During this process, a maximum of 10 stocks were purchased within the materials sector. Stocks would be sold if their rank fell below the top 35 per cent of the universe. When sold, the positions were replaced with the highest ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 13.2 per cent while the S&P/TSX materials total return index advanced 6.1 per cent. The top 10 stocks that meet our requirements for purchase today are listed in the accompanying table.

As always, it is recommended that investors conduct their own independent research before purchasing any of the investments listed here.

Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.

Select TSX-listed materials stocks

RankCompanyTickerMarket Cap ($Mil)Earnings Variability5Yr Normalized CF Growth Rate (%/year)CF to Debt Ratio*Enterprise Value to EBITDATrailing Rtn on Equity (%)Dividend Yield (%)
1Labrador Iron OreLIF-T 1,394.6 12.44.4n/c6.726.94.6
2Westshore TerminalsWTE-T 1,771.3 11.25.3n/c9.918.52.6
3Western Forest ProductsWEF-T 1,033.2 13.221.5n/c6.415.73.1
4Teck Resources Ltd.TECK.B-T 16,562.8 11.55.90.93.615.60.7
5Stella-Jones Inc.SJ-T 3,522.3 8.121.40.516.512.90.9
6Cascades Inc.CAS-T 1,168.8 10.316.60.27.45.61.3
7Premier Gold Mines Ltd.PG-T 733.8 17.827.4n/c3.212.70.0
8Russel Metals Inc.RUS-T 1,767.9 9.6-12.10.610.112.75.3
9Lucara Diamond Corp. LUC-T 914.5 20.527.2n/c4.340.04.2
10Canfor Corp.CFP-T 3,473.7 15.712.71.45.518.70.0

Source: Morningstar Canada

*n/c denotes that the company has no debt on the balance sheet