05 Oct 2021

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Anthony Menard

Floor-and-ceiling strategy opens door to mispriced stocks

Anthony Menard 05 Oct 2021

WHAT ARE WE LOOKING FOR?

Profitable companies that have a sensible price.

Return on capital and price-to-book tend to evolve in the same direction. As profitability rises, the price-to-book ratio is likely to increase to compensate for higher profitability. But what if we established lower and upper limits – such as a floor for profitability and a ceiling for valuation? Today, we’ll use such floor and ceiling limits to help us discover mispriced stocks.

THE SCREEN

We screened Canadian stocks focusing on the following criteria:

• Market capitalization higher than $2-billion;
• Return on capital higher than 10 per cent (we want a profitable company – this is our profitability floor);
• Price-to-book lower than 2.5 (we want a company with moderate valuation based on shareholder’s equity – this is our valuation ceiling);
• Positive three-month price growth (that is, a company with a positive trend in its share price);
• Positive two-year sales growth (we want a growing company);
• Positive one-year growth in current operating value (COV) – we want a company with improving fundamentals. We use discounted cash flow to derive the COV. The difference between the COV and a traditional DCF is that we assume the company will generate the same cash flow forever. In other words, we do not incorporate any growth component into the calculation. It is a way to evaluate the minimum value of a business; the parameters are determined automatically by our platform.

For informational purposes, we have also included price-to-earnings, three-year annualized growth in earnings per share, dividend yield and one-year price return. Please note that some ratios may be shown as of end of previous quarter.

MORE ABOUT INOVESTOR

Inovestor for Advisors is a fundamental-analysis research platform specializing in the economic value-added (EVA) approach. With Inovestor, advisers can quickly identify attractive investment opportunities, outsource their stock picking by using model portfolios, and easily communicate investment decisions with clients through client-friendly reports.

WHAT WE FOUND

Financial conglomerate Power Corp. of Canada has the highest three-year annual EPS growth on our list, at 22.4 per cent. (One of the public companies in which it owns a majority stake, Great-West Lifeco Inc., also made the screen). The jump of 31 per cent in Power Corp.’s current operation value is possibly related to the revised valuation of Wealthsimple Inc., one of its private investments, which surged from $1.4-billion to $5-billion between October, 2020, and May, 2021. Wealthsimple is well known for its robo-adviser and low-fee brokerage accounts.

Summit Industrial Income REIT has seen the largest three-month price increase (30 per cent) and three-year EPS growth (109.7 per cent) of our screen. Real estate investment trusts register fair value adjustments to reflect the increased value of their properties. For Summit, year to date, these adjustments already amounted to $693-million, which helps explain the jump in its unit price over the past three months. This year is exceptional, but Summit has shown constancy in reporting this kind of adjustment, with an average of $150-million a year in such adjustments in the past three fiscal years.

Natural gas producer Tourmaline Oil Corp. has achieved impressive two-year sales growth (83.8 per cent) and three-year annualized EPS growth (36.3 per cent) despite a challenging environment. Pension fund giant Caisse de dépôt et placement du Quebec said last week it will exit oil company investments next year, but will remain invested in companies involved in infrastructure such as pipelines and in natural gas activities. If oil becomes the next coal, so to speak, in the eyes of pension funds and other institutional investors, it could have an impact on oil producer share prices in the short-term. In this situation, natural gas companies could be an interesting alternative.

Although we did not filter stocks based on P/E and dividend yield, we note the median P/E of our list is 10.2, the median dividend yield is a respectable 2.7 per cent (not shown), and every stock pays a dividend.

Investors are advised to do further research before investing in any of the companies listed in the accompanying table.

Anthony Ménard, CFA, is vice-president of data management at Inovestor.

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