WHAT ARE WE LOOKING FOR?
Today we look at the ability of large-capitalization companies to generate superior profits based on their return on capital.
Matt Kacur, president of FSA Financial Science and Art Ltd. of Toronto, has developed and licenses a software program to undertake a quantitative and mathematical analysis to determine future profitability.
The Return on Capital Report is done in conjunction with Haywood Securities Inc. analysts, who provide the analytic or subjective assessments of companies in the screen to adjust for discrepancies between the model’s valuation and the current stock market.
This helps identify changes in trends and outlook to determine both undervalued and overvalued companies.
MORE ABOUT THE SCREEN
Reported earnings are not the only way to assess the profitability of a company. Moreover, profit 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 Return on Capital 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 does so from the asset side of the balance sheet. 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 invested capital (total assets plus accumulated depreciation), which is adjusted for inflation before short-term liabilities are deducted.
The return is based on the present value of the cash flow over the estimated life cycles of the assets. The cash flow calculation is made putting debt and equity on an equal footing by adjusting the operating profit by a normalized tax rate. Financial companies are not included in the model.
HOW HAS THE REPORT PERFORMED?
The large-capitalization portfolio – a group of 20 to 30 companies with a capitalization of greater than $1-billion screened from the total – has generated a year-to-date return of 24.9 per cent, compared with the returns for the S&P/TSX 60 and S&P/TSX composite indexes of 20.5 and 20.9 per cent, respectively.
Since inception in early 2004, the large-cap portfolio had an average annual return of 8.1 per cent, compared with 6.4 per cent for the S&P/TSX 60 and 4.3 per cent for the S&P/TSX composite index.
WHAT WE FOUND
The average projected upside return on the top 10 large-cap companies using the base-case scenario is 34.9 per cent, which is twice the downside risk, according to the Return on Capital Report.