What are we looking for?
Following the Number Cruncher I did almost exactly a year ago, I thought it would be interesting to update readers on how a portfolio of “pricey” stocks in that article has performed over the past year, which included the correction between October and December. Second, I screened for an updated list of stocks with hefty premiums. Like last year, the goal is to determine whether such premiums are justifiable by looking at each stock’s economic performance and growth.
Using Inovestor’s database, we screened the S&P/TSX using the following criteria:
To find the most overvalued stocks, we looked for 14 companies with the highest future-growth-value-to-market-value ratio – FGV/MV represents, as a percentage, the portion of market value that exceeds the company’s current operating value. The higher the number, the higher the baked-in premium for expected growth and the higher the risk. A negative number reflects a discount. For example, a future growth value of minus 50 per cent means the market value would need to increase by 50 per cent to equal what the company is worth if its operating profit stays flat forever.
To analyze the stocks, we added the following metrics to our table:
- The economic performance index, or EPI (return on capital divided by cost of capital). An EPI ratio of one or more indicates a company’s capacity to create wealth for its shareholders (a higher EPI displays a greater rate of wealth creation). A number lower than one means the company is destroying shareholders’ wealth;
- The return on capital;
- The one-year sales change;
- The free-cash-flow-to-capital ratio. This metric gives us a sense of how well the company uses the invested capital to generate free cash flows, which could be used to stimulate growth, pay and/or increase dividends, reduce debt, etc. A positive figure is good, 5 per cent and above is excellent.
The stock price, dividend yield and one-year price return are displayed for informational purposes.
More about the Parent-Paiement team at NBF
Jean-Didier Lapointe works with portfolio manager Carl Parent, CFA, who has 25 years of experience and manages more than $1-billion in assets for high-net-worth families across Canada. Our team believes in a holistic wealth management approach to help clients meet their financial and personal objectives. Fundamental analysis plays an important role in our investment process to identify high quality companies trading at attractive multiples.
What did we find?
Beginning with the performance of last year’s screen, the significant premiums had an obvious affect on the portfolio’s behaviour during the market downturn. On average, the stocks lost 15.5 per cent between Jan. 29, 2018, and Jan. 25, 2019, versus the S&P/TSX, which lost 4.5 per cent. During the October-December correction, the stocks in last year’s portfolio lost an average 29.8 per cent, versus the S&P/TSX, which lost 14.3 per cent.
Why did they underperform so badly? They were priced for perfection. When a company priced for perfection misses analysts’ estimates or reduces its guidance, it tends to be a lot more volatile than a fairly priced stock. It’s the same when the entire market goes down; stocks carry large premiums suffer most. If you agree with economists who think we are approaching the end of the cycle and care about capital preservation, being cautious about not having a large portfolio weight in these types of names makes a lot of sense.
Now, to our new list of 14 companies, shown in the accompanying table: Three of them have robust fundamental ratios that can somewhat justify (at least in part) the premium. Canada Goose Holdings Inc., Kinaxis Inc. and Kirkland Lake Gold Ltd. all generate positive wealth for shareholders with an EPI above one, positive free cash flows and strong revenue growth over the past 12 months. If these metrics stay as good, the premium can be sustainable.
Investors are advised to do additional research or consult their adviser prior to investing in any of the companies mentioned. This content is published solely for informational purposes and should not be construed as a recommendation to buy or sell any security.
Jean-Didier Lapointe is an associate investment adviser with the Parent-Paiement team at National Bank Financial.