Lower stock prices after a market pullback can be misleading as investors may be tempted to pick up bargains, only to end up buying companies with more downside potential. Therefore, we need to differentiate between real value and value traps. Today we will identify Canadian stocks that are potential value traps.
We screened the S&P/TSX Composite Index using the following criteria:
- A future-growth-value-to-market-value (FGV/MV) ratio of 5 per cent or higher. Since we want to identify value traps, we are searching for a positive FGV/MV, as this translates into an overvalued stock. (This metric represents the proportion of the market value of the company that is made up of future growth expectations, rather than the actual profit generated.) The higher the percentage, the higher the baked-in premium for expected growth and the higher the risk;
- An economic performance index (EPI) maximum of one. The EPI is the ratio of return on capital to cost of capital and ultimately reflects the wealth-creating ability of the stock. By selecting an EPI equal to or less than one, we are hoping to distinguish the companies that are unable to generate positive wealth for shareholders;
- A change in return on capital that is either stable or declining over 12 months and 24 months;
- A negative free-cash-flow-to-capital ratio. This ratio gives us an idea of how effective the company is in converting its invested capital to free cash flows, which is the amount left after all capital expenditures have been accounted for. It is an important measure as it gives us the company’s financial capacity to pay dividends, reduce debt and pursue growth opportunities. A negative number means the company is inefficiently managing its cash flows from operations;
- Market capitalization, dividend yield and 12-month return on capital are displayed for informational purposes.
MORE ABOUT INOVESTOR
Inovestor for Advisors is a research platform application based on the economic profit approach. It aids advisers in quickly identifying attractive investment opportunities and easily communicating them to their clients. In addition to providing detailed reports on more than 13,000 companies (Canadian stocks, U.S. stocks and American depositary receipts), Inovestor allows investors to create personalized filters and build custom portfolios.
WHAT WE FOUND
Almost 80 per cent of our results emerge from the utilities, energy and materials sectors. The key metric in this filter is the future-growth-value-to-market-value ratio.
For example, Fortis Inc., an electric-utility holding company based in St. John’s, is at a 20-per-cent premium and has an EPI of 0.9, which declined from its prior year’s EPI of 1.1. What this means is that the company’s value-creating ability has declined whereas the price of the stock hasn’t followed through yet.
Another electric utility that experienced a similar drop in its value-creating capability, but which is still trading at a premium, is Halifax-based Emera Inc. Its EPI dropped from 1.6 to 0.8 over the past year.
Such companies need to generate higher profits or meet growth expectations to be a sustainable investment. More generally, investors are advised to do further research before investing in any of the companies that appear in Number Cruncher.
Source: The Globe and Mail