Alvin Lau is an investment analyst at Longview Asset Management Ltd. in Toronto.
What are we looking for?
Growing Canadian companies with a history of high returns on invested capital (ROIC) that are also trading at relatively inexpensive valuations. Why? Because the increase in the economic value of a business depends on a combination of its ROIC and growth.
ROIC is a company's earnings before interest and taxes (EBIT) divided by its invested capital (working capital plus fixed assets). It is a measure of a company's efficiency in allocating its capital to profitable investments. We use EBIT rather than net income in our ROIC calculation, as it allows us to put companies with different levels of debt and tax regimes on an equal footing.
The longer a business can sustain a ROIC greater than its cost of capital, and the greater the spread between the two percentages, the more value it will create. A consistently high ROIC is usually indicative of a sustainable competitive advantage, which is what Longview looks for in the companies it owns.
My colleague, Kelly Brown, and I used the S&P Capital IQ Screener to search for Canadian companies with a five-year average ROIC of more than 15 per cent, and a minimum earnings per share (EPS) growth rate of 5 per cent over the past five years. To increase the chances of finding underpriced companies, we excluded companies that had enterprise value (EV) to EBIT multiples greater than 10. EV is equal to the market value of a company's equity, plus all of its interest-bearing debt, less any excess cash.
We also excluded any company with a market capitalization less than $300-million, a total-debt-to-capital ratio of more than 50 per cent, and companies in the financial sector, as the value of such companies is best measured by other metrics.
More about S&P Capital IQ
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What we found
Our screen produced 10 results. Outside of the resource-based companies, Logistec Corp., Medical Facilities Corp., and Metro Inc. appear to be interesting investment candidates. But, as always, please do your own research before investing in any of these stocks.