Allan Robinson
Today we are looking at the ability of natural resource companies to generate superior profits based on their return on capital.

Matt Kacur, president of FSA Financial Science & Art Ltd., has developed and licenses software to undertake a quantitative analysis of cash flow to determine future profitability.

The Return on Capital Report is done in conjunction with Haywood Securities Inc. analysts, who provide the assessments of companies in the screen to adjust for discrepancies between the model’s valuation and current stock prices. This helps to identify changes in trends and outlook to determine undervalued and overvalued companies.

More About The Screen

Most investors look at a company’s earnings to see how profitable a company 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 the business.

The ROC Report analyzes about 180 companies and ranks them according to their cash flow internal rate of return. Today, we’re looking at natural resource companies included in this report.

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 cycle of the assets. The cash flow calculation is made by putting debt and equity on an equal footing by adjusting the operating profit by a normalized tax rate.

How Has The Report Performed?

The report generates two portfolios, one with small-capitalization stocks and the other large-cap. Each portfolio comprises a list of 20 to 30 companies. Since its inception in early 2003, the small-cap portfolio has generated an annualized rate of return of 21.8 per cent, while the large-cap portfolio, which started a year later, has an annual return of 9.4 per cent. Both have outperformed their comparative indexes on the S&P/TSX.

What we Found

Today’s focus on natural resource companies reflects their importance in the performance of the Canadian stock market. Energy and materials account for 47 per cent of the S&P/TSX by market value.

Haywood Securities specializes in oil and gas and mining research. “They [the companies in the natural resources group] really screen quite well in most cases,” Mr. Kacur said.

The different returns between the various scenarios in the ROC Report have narrowed with the end of the credit crisis, Mr. Kacur said. “The model just chugs along, but the scenarios are driven by the analysts,” he said. “In times like now when things are more secure, the ranges tighten.”