This year marks the fourteenth anniversary edition of what long-time readers know as the MoneySense Top 200, where we crunch numbers on the largest blue chips. We now call it the All Star report, because the ultimate goal after all that crunching is to identify the All Star stocks that emerge as top prospects for the coming year.
The All Stock stocks report is packed with all the facts, figures, and analysis that you’ve come to expect. This year we’ve completed our move online and included a few extra features along the way. So settle in and learn about our new team of All Stars, those special stocks that sport strong characteristics as measured by both growth and value.
We’re pleased to say that our track record has been highly profitable over the years. Our All Stars climbed by an average of 14.6% per year since we started in 2004, not including dividends. That assumes an equal dollar amount was put into each All Star stock in the first year and rolled into the new All Stars each year thereafter. By way of comparison, the S&P/TSX Composite (as represented by the iShares XIC exchange traded fund) climbed by 4.8% per year over the same period. The All-Star stocks beat the market by an average of 9.8 percentage points per year.
Here is another way to look at it, to put it in dollar terms. If you had split $100,000 equally among the original All Stars and moved into the new stocks each year, your portfolio would now be worth approximately $585,000. That’s more than five times your original investment. Those who invested in the index fund turned their $100,000 initial investment into only about $184,000.
Last year proved to be another profitable one: the All Stars gained 13.5% since the picks were revealed a year ago, beating the S&P/TSX Composite by 6.4 percentage points over the same period. (These return figures do not include dividends and are even higher when they’re included.)
It is important to point out that our method has had its ups and downs over the years. For instance, the market suffered from a crash of historic proportions in 2008 that saw the All Stars lose almost 33% from November 2007 to November 2008. In addition, the All Stars trailed the market in four of the last thirteen annual periods.
While we’d love to be able to say that market crashes and downturns are a thing of the past, seasoned investors know that every stock-picking method stumbles from time to time. We fully expect the All-Stars to trail the market, or even lose money, on occasion. In addition, some individual stocks will inevitably disappoint. While we do our best to avoid such situations, investors can’t enjoy the market’s rewards without taking on some risk and sticking with a strategy.
The All Star stocks report evaluates the 200 largest companies in Canada (by revenue) using data from Bloomberg. (This year we also stuck to stocks with market capitalizations in excess of $100 million.) Each firm is graded in two fundamentally different ways. First we consider a stock’s merit as a value investment and then we determine its appeal as a growth investment.
Our value and growth tests employ a bevy of detailed calculations that are based entirely on the numbers. Our gut feelings or intuitions about a company don’t enter into it. But, at the end of the day, we sum up everything about a stock in two easy-to-understand grades with one for value and another for growth.
The grades work just like they did when you were in school. The top of the class get As. Solid firms get Bs or Cs. Those that are lacking get Ds or even Fs. Stocks with good grades are deemed to be worthy of consideration while those at the bottom of the class should be treated with caution.
The select group of stocks that get at least one A and one B on the value and growth tests are teamed up in the All Star list. But, before we reveal this year’s top stocks, let’s take a closer look at how the grades are awarded.
Value investors are bargain hunters at heart. They like solid stocks selling at low prices. That’s why we prefer companies with low price-to-book-value ratios (P/B). This ratio compares a firm’s market value to the amount of money that could be theoretically raised by selling its assets (at their balance-sheet values) and paying off its debts. A low P/B ratio provides some assurance you’re not paying much more for a company than its parts are worth. To get top marks for value, a stock must have a low price-to-book-value ratio compared to the market and also compared to its peers within the same industry.
We also track price-to-tangible-book-value ratios. Tangible book value is like regular book value, but it ignores intangible assets like goodwill. It’s a more rigorous test of how much a company would be worth if it had to be liquidated.
Assets are one thing, but it’s also important to examine a company’s bottom line. We prefer profitable companies and award higher grades to firms with positive price-to-earnings ratios based on their earnings over the past 12 months. We also reward a company when analysts expect it to be profitable and have a positive P/E over the next year. (This number is known as the forward P/E ratio.)
Because we know investors like to rub more than a couple of nickels together, we award extra marks to firms that pay dividends. As it happens, dividend-payers have generally outperformed miserly firms that don’t pay dividends.
For safety’s sake we also want to make sure a company hasn’t loaded up on debt. That’s why we award better grades to firms with low leverage ratios (defined as the ratio of assets to stockholder’s 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 time around.
Growth investors love firms with increasing 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 track each firm’s growth in total assets over the last year to get a sense of the momentum in its business.
While fundamental growth is great, we like it when the market takes notice. That’s why we give higher marks to stocks with solid returns over the past 12 months.
In addition, we want to make sure that companies use their capital wisely. To do so, we track each stock’s return on equity, which measures how much a firm is earning compared to the amount shareholders have invested. Return on equity is a measure of business quality and we give higher marks to those firms that outperform their peers.
We don’t want to take on too much risk and weigh up each stock’s price-to-sales ratio, which as you might expect, compares its price to its sales. We figure stocks with low-to-moderate ratios are reasonably priced while those with extreme ratios run the risk of collapsing.
We put all these factors together to determine each stock’s growth grade. As with value, 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.