This article in Star Sunday says HBC is the only value stock left in Canada! (that met their criteria)http://www.thestar.com/NASApp/cs/ContentServer?pagename=thestar/Layout/Article_Type1&c=Article&cid=1035777081236&call_page=TS_Business&call_pageid=968350072197&call_pagepath=Business/News
Jan. 27, 2003. 09:51 AM
GERARD DUBOIS ILLUSTRATION FOR THE TORONTO STAR
Surely, every investor wants to find that undervalued stock and watch it soar.
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Searching for investment gold
JASON KIRBY AND PETER VERBURG
CANADIAN BUSINESS
What would Benjamin Graham think about all this? The collapse of stock prices, we mean.
To listen to the gang on the Street, you'd think the market malaise of the past couple of years has made for a perfect buying opportunity. Indexes across North America and most of the rest of the world have plunged anywhere from 30 per cent to 50 per cent since the heady days of early 2000.
Every month or so, it seems, the odometer tracking the amount of wealth that's been wiped out rolls over by another $1 trillion. And the day traders and "hot-stock" crowd are in full retreat. Fear rules the market. Or does it?
Since multiyear lows were reached in October, the S&P/TSX Composite, S&P 500 and Dow indexes are all up by about 20 per cent. And if anything should raise a red flag, those technology sector analysts are quietly getting bullish again.
So what would Ben say? After all, the name Graham — the Dean of Wall Street and the man who taught Warren Buffet the ropes — is synonymous with a concept that is often repeated, but rarely achieved: "Buy low, sell high."
His books, especially The Intelligent Investor, are considered required reading for all who want to legitimately call themselves true "investors." With that in mind, we decided to put some of the criteria that Graham and other well-known and — more important — successful value investors use when they're analyzing companies. In the end, what we found suggests that the markets in general — and almost all stocks in particular — are still largely overvalued.
First, you've got to realize that everyone has a different take on what constitutes value, even the big guns. So, drawing up a definitive list of value criteria is difficult. But we looked at the ratios and valuations that Graham, Buffett, Charles Brandes (of Brandes Investment Partners, a prominent San Diego value manager), Irwin Michael of ABC Funds (one of Canada's most successful value-oriented fund managers) and others look for, and came up with an amalgamated value screen that we think should help you find some companies to watch, as either pure value plays now or potential bargains in the future.
Price to earnings: Even kids these days have a vague concept of what a P/E ratio is (you know, share price divided by 12 months of earnings per share). In a general sense, P/E reveals how investors at large view a company's prospects; on the downside, that also makes it something of a beauty pageant score.
Graham's rules for what constitutes value were strict. For instance, a P/E must be less than the inverse of the yield on a AAA corporate bond, which at 6.3 per cent means a P/E ratio of 15.6, and be less than 40 per cent of the average P/E over the last five years. On the other hand, some value investors consider only stocks that are trading for less than a P/E of 10.
In our search for bargains, we had trouble finding companies that fit the bill. No wonder. The trailing P/E ratio for the S&P 500 is still 29, well above the 17 mark the index averaged from 1960 to 2002. For the S&P/TSX, it's a whopping 39.7. This suggests that earnings are still weak, and stock prices haven't fallen enough to reflect that fact. Having said that, some company earnings were severely depressed by write-offs last year; those P/E ratios might look high at the moment, but would look cheap in a good economy.
Price to cash flow: Since earnings have become so sketchy — thanks to Enron, WorldCom and the other hundreds of companies that restated profits and losses last year — it pays to consider the P/CF ratio, which is harder to fudge. With cash flow, you get a better sense of a company's ability to pay debts and create value through reinvestment, dividends or stock buybacks.
According to our amalgamated value criteria, a stock should have a P/CF ratio of less than five.
Net working capital: Graham was a huge fan of this gauge of value, which looks at a company's short-term solvency (things like current assets such as cash and accounts receivables minus current liabilities). As a safety measure, he argued that current assets should be at least twice the value of current liabilities. Graham's most famous theory was that if a stock trades for less than two-thirds of net working capital — and is profitable — investors should buy it. Needless to say, such deep discounts are difficult to find.
Price to book value: What value investors often look for are companies that trade at a discount to their book value, so anything below a multiple of one starts to look good. If possible, try not to include intangible assets, like goodwill, in the equation. Remember, in 2001 JDS Uniphase Corp. wrote down more than $45 billion (U.S.) of goodwill from its balance sheet.
Debt to equity: This is a biggie to watch for these days, with many firms getting in over their head into debt. You simply take the total debt as listed on a company's balance sheet, and divide it by the book value. For our value-oriented search, we went looking for companies with a D/E ratio of 0.5 or lower. If you were strict about this when investing, you'd have to ignore more than a quarter of the companies on the S&P/TSX composite index.
Dividend yield: Cheap stocks are great, but the surest sign that a company's business is still on solid ground is whether it can make dividend payments to its shareholders.
With all the earnings troubles of the past year, some companies have had to cut their payouts. If you follow value guidelines, you should look for a dividend yield that's at least two-thirds of the yield you'd get from long-term government bonds; they currently yield about 6 per cent. To get a sense of where things stand, the average dividend yield of the S&P/TSX index is 1.87 per cent.
In our quest to separate real bargains from just crummy stocks, we considered a number of other criteria, including history of earnings growth, management performance, industry stability and earnings yield, but the valuation methods above were by far the most important. And the most cautionary.
In fact, the first time we ran a screen to capture companies that met all of our requirements, we turned up some pretty slim pickings. We found only one sizable company — Hudson's Bay Co. (TSX: HBC) — and though we include it here because its stock is at fire-sale prices, there are still serious concerns about its ability to grow its bottom line.
So we went back and softened our demands bit by bit. In the end, we selected a handful of stocks that meet some of our ideal targets, but not all.
If you don't mind the extra risk, they might warrant a look now. Otherwise, they might be worth keeping on the radar in the coming months to see if their ratios improve. We think that's what Graham would do.
Hudson's Bay Co.
Many investors have lost faith in the Hudson's Bay Co. No wonder.
The company, which operates more than 500 Bay, Zellers and Home Outfitters stores across Canada, is struggling to find its footing in a transformed retail landscape of Wal-Marts and big-box stores.
As a result, HBC's profits have been squeezed, and its stock price plunged last fall to a historic low of $5.90 per share.
Shares in Canada's oldest retailer have since rebounded to about $9.50 on improved net earnings — $7.7 million in the third quarter, up from $4.5 million during the same quarter last year — as it stopped offering storewide discounts and launched an aggressive marketing campaign.
Despite the run-up, HBC's ratios still make it attractive. For one thing, it is trading at just 30 per cent of its book value, and its price-to-earnings ratio is about 11.7. HBC has also made great strides in reducing its long-term debt, which now sits at $838 million. Last fall, the company reported its debt-to-equity ratio declined to 36 per cent, down from 48 per cent during the same period a year earlier.
But the best reason to buy HBC is that the company's stock is trading for less than two-thirds its net working capital.
Now, if it were all about ratios, you'd think HBC stock was on sale during one of the retailer's once-famous Bay Days. But revenues, as well as same-store sales, have slipped, driving home the point that the retail sector is still brutally competitive. Should Canada's retail market solidify and the company manage to find its footing against Wal-Mart, however, strong fundamentals should lead HBC's shares to rebound and value investors to gloat about the stock they bought on sale.
Duke Energy Corp.
In tremulous times, stocks offering safety and value are a nice addition to any portfolio. If the shares come with a dividend, all the better. One of the best places to find financially solid companies with high dividend yields is the energy sector.
Firms involved in producing and distributing power and natural gas have been in the doghouse since Enron and the California pricing scandal rocked markets, but the negative investor sentiment has created some interesting opportunities.
One player that merits investigation is Charlotte, N.C.-based Duke Energy Corp. (TSX: DX). The power and natural gas distribution company acquired Vancouver-based Westcoast Energy last March — one of the few bright events in a difficult year that saw Duke's stock lose almost 60 per cent of its value.
The company was forced to lower its earnings forecast twice during the year, due largely to a downturn in the wholesale power markets.
Are the hard times over? Difficult to say. Duke could face more challenges in the year ahead. However, the company is poised to benefit from any recovery in the power market, and the stock is attractively priced. Duke was recently trading near its book value, with a 2002 earnings multiple (excluding extraordinary items) of about 10.4. The firm has reasonable debt for a utility, stable cash flow and it has reported earnings growth of 5.5 per cent per year over the past 10 years.
At a recent price of $26.95, Duke's Canadian-listed common shares offer a dividend yield of 6.4 per cent. The company has paid a cash dividend for 77 consecutive years - not a bad record. The dividend should limit downside risk, as noted by New York research firm Value Line in a recent report.
Another consideration is TransAlta Corp. (TSX: TA). At $17, the stock is yielding 5.9 per cent. It trades at a low earnings multiple relative to its peers, and the outlook for the coming year is positive. However, TransAlta's historical earnings record is not as good as Duke's, and recently announced changes to the dividend policy in the United States could work against Trans Alta as American investors shun high-yielding Canadian stocks for U.S. issues.
CAE Inc.
Even great managers have a tough time making their stock perform when the industry they operate in is out of favour with investors. Case in point: CAE Inc. (TSX: CAE).
The Toronto-based maker of flight simulators and military training systems is a technology company that builds products for the airline industry — in other words, it has ties to a sector of the economy that is in the dumps.
Not surprisingly, CAE's share price has been pummelled over the past year, dropping from a high of $14.60 last spring to a low of $3.25 when markets bottomed out in October.
The stock has bounced back somewhat since then, after the company announced a series of new contracts in December and January. The shares closed Friday at $5.22. But that's still about 63 per cent off the 52-week high.
There's still plenty of upside potential in CAE for patient investors. Problems in commercial aviation — highlighted by the recent bankruptcy filing of United Airlines — have reduced near-term demand for CAE's full-flight training simulators. But it is a leader in the area, and should do well in the recovery.
In the meantime, CAE's military and marine units are making gains. In January, for instance, CAE was awarded a $28 million contract by the Department of National Defence to provide a new flight-deck simulator.
In addition, the company recently announced contracts with the U.S. Army and U.S. Air Force. CAE is also building a global network of civil flight-training facilities, a line of business with excellent growth potential. It hopes to have 90 simulators installed by the end of the fiscal year, generating an estimated $275 million in revenues, compared with $100 million last year.
In terms of valuation, CAE looks attractive on several fronts. It trades at a low earnings multiple relative to its peers. The price-earnings ratio is 7.7, based on 12-month trailing earnings of 69¢ a share. The company has declared a dividend of 12¢, generating a yield of about 2.2 per cent. Its earnings have grown by an average of 19.5 per cent per year over the past decade, and it expects a net profit margin of 20 per cent this year. The balance sheet is in reasonably good shape.
The bottom line: CAE has both good management and excellent prospects. Big gains in the stock price may not occur until the aviation sector sees some recovery in two to three years. But as a strong player in a weak industry, CAE should appeal to contrarian investors with a long view.
Power Financial Corp.
Establishing Power Financial Corp.'s (TSX: PWF) enduring legacy of strong performance is easy. It has boasted impressive growth in both dividends and earnings per share.
In fact, over the past 25 years, the company has provided an average return of about 23.8 per cent, besting American wealth-building icons like General Electric and Warren Buffett's Berkshire Hathaway Inc.
Power Financial is a leading player in both the insurance industry (through its ownership of Great-West Lifeco Inc. and London Life Insurance Co.) and in mutual funds (through Investors Group Inc., which swallowed Mackenzie Financial Corp. in 2001). That makes for a formidable distribution network.
And in November, that network was reinforced when Investors Group, Great-West and London Life signed a private-label banking distribution agreement with National Bank of Canada.
At about $38, it's more difficult to argue that Power Financial's stock is a bargain. It has a lukewarm price-to-earnings ratio of 14.8, and doesn't trade at a discount to book value, either. Its price to cash flow stands at 5.6 (just above our criterion), while it offers a moderate 3 per cent dividend yield.
The obvious attraction is its ultra-low debt-to-equity ratio of 0.28, owing to the company's highly conservative management style.
Power Financial is simply not facing any present crisis that would rob it of a price reflecting its past performance.
Dividends increased again at both Great-West and Investors Group in 2002, despite the harsh climate. While Investors Group's net fund sales are way down, it's faring better than the rest of the industry. The Mackenzie merger appears well-executed, to boot.
BMO Nesbitt Burns analyst John Reucassel has expressed concerns about productivity and recruitment problems in its subsidiaries' sales force, but, nevertheless, calls Power Financial one of his favourite stocks. So, while not an ideal value investment by most measures, it may still be attractive to the long-term investor, and certainly a financial services company worth watching - not least because it has raised a $1.2 billion war chest it could use to further consolidate its leadership position.
West Fraser Timber Co. Ltd.
When things get bad, value investors look for bargains — and things have been pretty ugly for Canada's lumber producers. The hewers of wood have had to deal with low lumber prices and the imposition of a massive U.S. tariff that all but slammed the door to the producers' largest market.
But not all Canadian lumber mills are bleeding red ink. Vancouver-based West Fraser Timber Co. Ltd. (TSX: WFT), which produces pulp, lumber and other wood products, posted a profit despite the chaotic market.
The company's stock has bounced from the 52-week low of $28.90 it hit in October to now trade about $35, after reporting improved efficiencies at its pulp and lumber mills. The company reported a profit of $102 million on revenue of more than $1.2 billion in the first nine months of last year, down from a profit of $104 million on revenue of $1.2 billion a year ago.
Despite the surge in West Fraser's stock price, the company's price-to-earnings ratio is still a decent 9.4, and its price-to-cash flow ratio is 4.2. Its debt-to-equity ratio is 0.50 — also well within the guidelines of a value stock.
West Fraser is flying high compared with such competitors as troubled Doman Industries Ltd., which is under creditor protection. Canfor Corp. (TSX: CFP) — one of West Fraser's largest competitors and the company spearheading a campaign to defeat the U.S. lumber tariffs — has shown profits over the past nine months, and has seen its stock recently rally to about $10. That's given Canfor's stock a price-to-earnings ratio of 17.9, with a price-to-cash flow checking in at 6.3 — well out of the running for a value stock.
The whole point of buying a value stock is to catch it on the downswing and ride it to its highs. Unfortunately, the future of the Canadian lumber industry is far from certain. West Fraser has warned investors that its upcoming financials won't be rosy, as the construction business moves into its usual winter slump. Ultimately, though, it is the U.S. tariff and health of the American economy that will determine the financial fortunes of West Fraser and others in the sector.
In the most recent quarter, the company had to fork over more than $19 million in duties to get its products south of the border. That's a high price to pay to do business — and should the U.S. economy weaken, further eroding demand for Canadian lumber, things could get worse.
Sobeys Inc.
Sobeys Inc. avoided any heat when CEO Bill McEwan received a hefty $1.64 million salary and bonus for running Canada's second-largest grocer in 2002. Frankly, it's peanuts in the global executive compensation environment.
And, hey, those holding Sobeys' shares (TSX: SBY) last year almost doubled their money. The question now is whether 2003 will be as kind.
After hitting a 52-week high of $45.75 in June, Sobeys recently traded for less than $40, despite strong results. (In the first half of fiscal 2003 the company posted net earnings of $92.5 million on $5.25 billion in sales, with earnings up 35 per cent from last year.) Market watchers foresee ongoing revenue and share gains.
In fact, buy ratings currently outweighed holds seven to one. Dundee Securities Corp.'s William Chisholm, one of the strongest Bay Street bulls following the firm's shares, has a 12-month target price of $46 on the stock. The analyst, who doesn't own shares in the company, says his reasoning is simple. According to Chisholm, Sobeys has solid management, a strong cash position and plenty of room to grow in Ontario, Canada's largest market, despite plans by Wal-Mart to open up to six Sam's Club warehouses in the province this year.
The Stellarton, N.S.-based firm pays a steady dividend (9¢ in the last quarter). And its P/E ratio is sitting at 17.4, less than industry giant Loblaw, which has a P/E of 21.5.
But if those reasons aren't enough to open your wallet, maybe you should consult the skies. After all, as a grocery chain, Sobeys — which expects operating earnings per share growth of between 12 per cent to 16 per cent for fiscal 2003 — will always be one of the safer places to park money whenever war clouds are on the horizon. |
