Allan Robinson
WHAT WE ARE LOOKING FOR?

Today, we look at the ability of small-capitalization companies to generate superior profits based on their return on capital. We’ll use a specialized Return on Capital Report managed by Matt Kacur, the president of FSA Financial Science & Art Ltd. of Toronto, which developed and licenses the software.

MORE ABOUT THE SCREEN

Most investors look at a company’s earnings to see how profitable it is. But earnings per share can be distorted by items such as amortization and depreciation. Some investors would rather look at calculations such as return on capital, which measures how well a company generates cash flow relative to the capital it has invested in its business.

The ROC Report analyzes about 180 companies and ranks them according to their cash flow internal rate of return. What makes this report different is that it adds back accumulated depreciation to net fixed assets to get gross fixed assets, which is the original amount of the investment. From this, a cash flow internal rate of return (a cash-on-cash return on capital) is derived. Most return on capital calculations are based on shareholders’ equity and debt.

The final analysis produces a quarter-by-quarter screen that sizes up a company’s ability to generate a return on the invested capital, or what can be described as the true economics of a business.

The report is done in conjunction with Haywood Securities Inc. analysts, who provide the analytic or subjective assessments of companies in the screen to adjust the discrepancies between the model’s valuation and the current stock prices.

HOW HAS THE REPORT PERFORMED?

The report generates two portfolios, one large cap (published yesterday) and the other a small cap. Each portfolio is a list of 20 to 30 companies.

On a year-to-date basis, the ROC small- and mid-cap portfolio generated a rate of return of 43.7 per cent, compared with 26.4 per cent for the S&P Canadian small-cap index.

Since its inception in February, 2003, the ROC small-cap portfolio has made an average annual return of 19.8 per cent, compared with a 0.8-per-cent return for the S&P Canadian small-cap index.

“We buy really good companies that we think are undervalued,” Mr. Kacur said. “Our cash flow internal rate of return framework, we think, has a more accurate return on capital than traditional accounting.”

In the table today, we will look at some of the most undervalued small-cap companies, according to Haywood Securities.

WHAT WE FOUND

Energy, drilling and power companies dominate the list of the most undervalued small-cap companies.