What are we looking for?
Reasonably valued Canadian companies with momentum and earnings to reinvest.
The screen
Equity markets have been continuing their upward trend, underpinned by generally strong and broadly based earnings growth. For instance, the average Canadian company has seen its latest quarter's earnings grow 16 per cent over the same quarter from one year ago. Estimates for next quarter push this figure to almost 28 per cent. Given the general strength in prices, however, some investors have been questioning whether valuations are sustainable.
My colleague Lawrence Ullman and I looked to the enterprise-multiple-to-growth (EMG) ratio in order to search for reasonably valued companies with room to grow. Similar to the price-earnings-to-growth (PEG) ratio, the EMG ratio compares valuations with growth levels by taking EV/EBITDA (total enterprise value divided by earnings before interest, taxes, depreciation and amortization) and dividing by the firm's sustainable growth rate (also known as reinvestment rate) in order to take growth prospects into account. We used Morningstar CPMS to find 10 Canadian stocks with the best mix of:
-EMG ratio (lower is better);
-Three-month consensus earnings estimate revision (cannot be negative);
-Latest earnings surprise – in other words, the latest reported earnings-per-share figure compared with the consensus estimate from the Street just prior to the company's report (cannot be negative);
-Three- and 12-month price change.
EMG values must be less than the database median, currently 1.76; market cap must be above $200-million; and the three-month price change cannot be negative.
More about the Ullman Group
The Ullman Group is an independent provider of strategic private capital management services to high-net-worth individuals, corporations, endowments, charities and foundations.
What we found
We used CPMS to perform a back-test starting Feb. 29, 2007, selecting an equally weighted portfolio of the top 10 qualifying stocks.
Universe rankings were regenerated monthly and holdings were replaced if their rank fell outside of the top 40 per cent, or if consensus estimates or price fell more than 15 per cent over three months.
Over the 10-year period, this strategy would have generated an annualized total return of 13.2 per cent compared with 4.7 per cent for the S&P/TSX composite total return index. Following the strategy over the past year would have resulted in a gain of 18.7 per cent, underperforming the index, which posted a gain of 23.2 per cent.
The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Investors should contact a professional or do their own research before investing in any of the stocks shown here.
Craig McGee, CFA, is a portfolio manager and Lawrence Ullman, MBA, is a director, wealth management and portfolio manager with the Ullman Group at Richardson GMP in Toronto.
Richardson GMP Ltd. is a member of Canadian Investor Protection Fund. Richardson is a trademark of James Richardson & Sons Ltd. GMP is a registered trademark of GMP Securities LP. Both used under licence by Richardson GMP Ltd.