Welcome to Canadian Business Heroes, which rates the largest 200 stocks in Canada while providing a bevy of facts and figures on each one. This year marks the fifteenth anniversary edition of the stock picking method and its pantheon of top stocks.
We size up each stock and industry in a multitude of ways and then distill all the data down into two easy to use letter grades. The first measures the value characteristics of each stock and the second sums up its growth prospects. We call stocks that rank highly on both metrics Heroes because we believe they have what it takes to succeed.
The Heroes have done well over the long term. They climbed by an average of 12.2% per year since we started way back in 2004 not including the dividends they paid along the way, which would have added a few percentage points to the total (Up until this year, it was published as the MoneySense All-Stars). The return assumes an equal dollar amount was put into each Hero in the first year and rolled into the new Heroes each year thereafter. By way of comparison, the S&P/TSX Composite (as represented by the iShares XIC exchange traded fund) climbed by 4.0% per year over the same period. The Heroes beat the market by an average of 8.2 percentage points per year.
The gains add up when put into dollar figures. If you had split $100,000 equally among the original Heroes and moved into the new Heroes each year, your portfolio would now be worth approximately $501,000. That’s more than five times your original investment. An investment in the index fund would have turned a $100,000 initial investment into about $174,000.
Unfortunately, the Heroes didn’t outperform every single year—and last year proved to be one such occasion when they fell short. The Heroes lost 14.4% since last time and trailed the S&P/TSX Composite (XIC), which itself lost 5.4%. It wasn’t a good showing. It marked the fifth time the Heroes lagged the market out of the last fourteen. It was third time they lost money.
(A quick aside on the return calculations is in order. The returns for the Hero portfolio and index do not include dividends and are based on periods between the data collection dates, which are highlighted in the each year’s comprehensive data table. They do not reflect calendar year-end figures. They also do not include taxes or other trading frictions.)
The Canadian stock market is currently in a correction. That is, the S&P/TSX Composite price index has fallen by more than 10% from its prior peak. Such setbacks are an unfortunate fact of life and investors should be prepared for them. While the markets may continue to slip in the short term, we think they’re likely to move a good deal higher over the long term. Good investors are patient investors.
Finding Our Heroes
To size up the largest stocks in Canada, we start by eliminating stocks with small market capitalizations, very low share prices, and other anomalies from consideration. We then pick the 200 largest companies in the land based on their revenues over the last year using data from Bloomberg.
The 200 large companies are graded in two distinctly different ways. First we weigh a stock’s merit as a value investment and then we evaluate its attractiveness as a growth investment.
While our value and growth tests employ a bevy of complicated calculations, they’re based solely on the numbers. Hunches, intuitions, or gut feelings don’t enter into it. Instead, we distill the numbers down into an easy-to-understand grade for value and another for growth.
The grades should evoke memories – and hopefully fond ones – of your school days. Stocks with the best prospects get As. Solid firms get Bs or Cs. Those with room for improvement might get a D or F. Stocks with good grades are deemed to be worthy of consideration while those at the bottom of the class should be treated with extra caution.
The select group of stocks that get at least one A and one B on the value and growth tests make it into the Hall of Heroes. Before we reveal this year’s Heroes, let’s take a closer look at the grading process.
Value investors are thrifty bargain hunters who like to buy solid stocks for low prices. That’s why we prefer companies with low price-to-book-value ratios (P/B). The ratio compares a firm’s market value to the amount of money it might theoretically raise by selling its assets (at their balance-sheet values) and paying off its liabilities. A low-P/B ratio indicates a company is likely selling for less than the value of its parts. To get top marks for value, a stock must have a low price-to-book-value ratio compared to the market and compared to its peers within the same industry.
We also like to size up a stock’s price-to-tangible-book-value ratio. Tangible book value is similar to regular book value, but it ignores intangible assets like goodwill. It’s a more stringent test of how much a company might be worth in liquidation.
Assets are good, but they should go hand in hand with profits. That’s why we prefer profitable companies with positive price-to-earnings ratios based on their earnings over the past 12 months. We also take note of firms when analysts expect them to be profitable over the next year, which means they have positive forward P/E ratios.
Companies transfer money to shareholders by paying dividends and we like to be paid. That’s why extra marks go to dividend payers. As it happens, dividend paying stocks have, as a group, outperformed non-dividend payers.
For safety’s sake we also want to make sure that a company isn’t perched on the top of a towering pile of debt. That’s why we award better grades to firms with low leverage ratios (defined as the ratio of assets to shareholders’ equity) relative to their peers.
All of these factors are combined into a single value grade. Only 20 out of 200 stocks got an A for value this year.
Growth investors are attracted to firms that are able to grow their sales and earnings. That’s why we award higher marks to companies that have achieved reasonable sales-per-share and earnings-per-share growth over the last three years. We also follow each firm’s growth in total assets over the last year to get a handle on the momentum in its business.
While sales and earnings growth is great, we want the market to take notice. That’s why we give higher marks to stocks with strong returns relative to the market over the past 12 months.
In addition, we want to make sure that companies shepherd their capital wisely. That’s why we size-up each stock’s return on equity, which measures how much a firm is earning compared to the amount shareholders have invested in it. We give higher marks to firms with industry-leading returns on equity.
Unrestrained growth can also be dangerous. To avoid taking on a huge amount of risk, we look for firms with low-to-moderate price-to-sales ratio. The ratio, as you might expect, compares a firm’s price to its sales. The idea being to avoid stocks that might be caught up in a speculative mania or bubble.
We put all these factors together to determine each stock’s growth grade. Only 20 out of the 200 got an A for growth this year.
Norm Rothery, CFA, PhD, tweets as @NormanRothery. He may hold some of the securities mentioned in this article. Be sure to read all of the sections of this feature before investing.