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Want to pick a tech winner? Stick to fundamentals

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For a lot of people who play the stock market, "the company" and "the stock" are pretty much interchangeable. But for Steve Arthur, being able to distinguish between the two is a key part of stock evaluation.

"You have to be able to separate the companies from the stocks," said Mr. Arthur, information technology analyst at RBC Dominion Securities Inc. in Toronto, who focuses first on a company's underlying fundamentals when considering which stocks to recommend.

"I don't get too caught up in stocks on the way up, or panic on the way down," he said. "Once we decide if we like the company, what do we think of the stock?"

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Mr. Arthur's fundamentals-first approach has served him well. The RBC analyst (who also tracks a handful of auto-parts makers) ranks first among StarMine Corp.'s rankings of Canadian IT equipment analysts, based on the performance of his stock recommendations for the past 12 months. He's also StarMine's top-ranked analyst in the sector for performance over the past 36 months.

Data compiled by StarMine - a stock market analytics service owned by Thomson Reuters - show that Mr. Arthur's recommendations generated excess returns of 15.4 per cent above the overall Canadian IT equipment sector over the past year, edging past Michael Urlocker of GMP Securities Ltd. (14.9 per cent).

StarMine's industry excess returns ratings use each analyst's stock recommendations to create a "long-short" investing strategy - mimicking the effect of going long on stocks the analyst rates "buy" and shorting the stocks he or she rates "sell". This way, the analyst gets credit for both "buy"-rated stocks whose returns exceed the overall industry benchmark, and "sell"-rated stocks whose returns underperform the benchmark. (Stocks rated "strong buy" or "strong sell" are awarded double credit; ratings of "hold" or "neutral" receive no score.) Tim Gaumer, director of fundamental research at Thomson Reuters, said Mr. Arthur's performance over both the past year and the past three years is even more impressive when you consider that the companies he covers are generally relatively small-capitalization IT firms.

"That has been a dangerous area to invest in in the past," he said. "It's not easy to outperform here."

StarMine's data show that when Mr. Arthur has had a stock rated "outperform" during the past year, it has risen an average of 52 per cent. When he has had it rated "sector perform" or lower, the average return has been just 1 per cent.

"He's very good at sorting his universe," Mr. Gaumer said.

Mr. Arthur is more than just a good stock picker - he's also among StarMine's top-rated analysts for the sector in terms of the accuracy of his earnings estimates for the companies he follows.

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"It's rare for someone to be good at both," Mr. Gaumer said.

But while this is testament to Mr. Arthur's talents in assessing a company's financial strength, the financials aren't his primary focus when doing his fundamental analysis.

"I consider financials to be one of the fundamentals, but not the most important one," he said.

"First off, it's great product positioning in a growing market. It's also strong management teams," he explained. "Then we look at the financials."

For example, he upgraded microchip designer Zarlink Semiconductor Inc. early last year "because we saw those factors coming through." The stock rose 55 per cent over the next 12 months.

The stock Mr. Arthur rated as his "top pick" last year was MacDonald Dettwiler and Associates Ltd. , a Richmond, B.C. data systems and services company. "It had all those characteristics we were talking about - and it was cheap," he said.

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Macdonald Dettwiler's stock rose a respectable 24 per cent over the past 12 months, but Mr. Arthur sees more upside: It remains his top pick this year.

"It's quite a different proposition than it was a year ago," he said, noting that the company recently sold its property-information business for $850-million. Now, he said, it is sitting on more than $1-billion in the bank, which could find its way to significant acquisitions, share buybacks or dividend payments - "any of which would be good for the stock."

"It's still inexpensive, and they have a great track record for capital development," he said.

As for the sector overall in 2011, Mr. Arthur is upbeat.

"The big-picture demand prospects are positive," he said, pointing to the need for increasing global network capacity as the world economy accelerates.

He also noted that price-to-earnings multiples for stocks in the sector are "still in the mid-teens," relatively low by historical standards.

"The valuations are still attractive, despite the price appreciations."

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About the Author
Economics Reporter

David Parkinson has been covering business and financial markets since 1990, and has been with The Globe and Mail since 2000. A Calgary native, he received a Southam Fellowship from the University of Toronto in 1999-2000, studying international political economics. More

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