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A Canadian Graham Stock

Over the last three years Iíve highlighted Benjamin Grahamís time-tested strategy for defensive investors in an effort to uncover undervalued U.S. stocks. Based on the relative success of the method, many people have asked me to apply the approach to the Canadian markets.

It is important to keep in mind that U.S. markets and Canadian markets are very different. First there is a matter of sheer scale. There are over 2,200 U.S. listed companies with revenues of more than $400 million whereas there are only 246 in Canada. Second, Canadian markets are more heavily concentrated in resources and financials whereas U.S. markets are concentrated in industrials and consumer products (See Table 1). Third, Canadian markets may be less efficient and more prone to market imperfections which should give value-based approaches a comparative advantage.

Table 1: U.S. vs Canadian Market Sectors
SectorS&P/TSX CompositeS&P500
Financial Services 31.10%20.50%
Metals and Minerals 17.20%2.90%
Oil and Gas 14.20%5.30%
Industrial Products 13.80%28.70%
Consumer Products 11.10%22.70%
Communication and Media 5.20%3.30%
Utilities 4.40%2.08%
Others 2.60%13.70%
Source: Globefund.com, Feb 3 2004, based on TD index funds


For those new to Graham, an updated edition of his book The Intelligent Investor (ISBN 0060555661) was released this summer with a forward by noted financial journalist Jason Zweig. Grahamís rules for defensive investors are briefly summarized in Figure 1. It is important to keep in mind that very few stocks meet Grahamís stringent rules for earnings growth at a low price and his method often rejects all stocks as unsuitable. In the United States rejection has certainly been the rule in recent times because most stocks trade at rich valuations. Based on the U.S. experience, and due to a smaller number of Canadian stocks, I was not overly optimistic that I would find any Canadian stocks matching the less stringent criteria (shown in Figure 2) that Iíve used in previous Canadian MoneySaver articles. Furthermore, Iíve yet to find a free Canadian stock screener that is nearly as good as MSN.comís deluxe screener. As a result, the search for Canadian Graham stocks is more time consuming.

Figure 1: Benjamin Graham's Criteria for the Defensive Investor
P/E Ratio less than 15.
P/Book Ratio less than 1.5.
Book Value over 0.
Current Ratio over 2.
Earnings growth of 33% over 10 years.
Uninterrupted dividends over 20 years.
Some earnings in each of the past 10 years.
Annual revenue of more than $100 Million (1950).
Source: The Intelligent Investor, 4th Revised Edition (pages 184-185).

Figure 2: Screening criteria used to approximate Graham's rules
P/E Ratio less than 15.
P/Book Ratio less than 1.5.
Book Value more than 0.01.
Current Ratio more than 2 .
Annual EPS Growth (5 Yr Avg) more than 2.9186%.
5 Year Dividend Growth more than 0%.
5 Year P/E Low more than 0.01.
1 Year Revenue more than $400 Million.


Undaunted, I started my search for Canadian Graham stocks by using the stock screener at globeinvestor.com. The globeinvestor.com screener yielded ninety-one Canadian stocks with revenues of more than $400 million and positive price-to-book values of less than 1.5. With the initial ninety-one stocks in hand, I removed the thirty-seven that did not pay a dividend and a further eleven that were not common stocks (unit trusts and preferred shares). The fourty-three remaining stocks were then subject to Grahamís requirement that stocks should trade at price-to-earnings ratios of less than fifteen. To perform the price-to-earnings test, I moved from globeinvestor.com, which has price-to-earnings figures that do not include extraordinary items, to the standard price-to-earnings ratios provided by TSX.com. It has been my experience that management shoves big losses into extraordinary items which tends to make recurring earnings look better. Extraordinary items have a strange way of recurring much too frequently for my taste. In any event, based on the TSXís more stringent price-to-earnings ratios, a further twenty-two stocks were rejected. I then moved to MSN.com, and looked for companies that had some earnings in each of the last five years. A total of seven stocks failed the earnings stability test. Next, I looked into the remaining stocksí financial statements to make sure that they had a current ratio (or ratio of current assets to current liabilities) of more than two. Only three of the remaining fourteen stocks passed this test. The three stocks were Tesma International (TSM.A), Wescast Industries (WCS.A), and ATCO Ltd (AXO.X). Wescast Industries (a stock that I hold) and Tesma International were disqualified for not having achieved sufficient earnings growth over the last five years. In the end, of the 246 Canadian stocks with revenues of more than $400 million, only ATCO managed to pass all of the tests shown in Figure 2.

ATCO is an Alberta based conglomerate with world-wide operations that is engaged in power generation, technologies, utilities, industrials, logistics & energy services. Over the last year the company posted sales of $3,925 million, earnings of $4.21 per share and it had a book value of $36.83 per share. At the close of February 2, 2004, ATCOís voting shares (ACO.Y) traded for $50.64 per share. As a result, the companyís price-to-earnings ratio was 12 and its price-to-book-value ratio was 1.38. As of last quarter, ATCO has a current ratio of 2.5 but its long term debt to equity ratio of 2.8 is a little higher than Graham would have liked. On the growth side, ATCO has a five-year average annual earnings-per-share growth rate of 10.1%. Dividend-oriented investors will appreciate ATCOís five-year average annual dividend-per-share growth rate of 19.1% and 2.5% dividend yield.

On the downside, ATCO has both voting (ACO.Y) and non-voting (ACO.X) shares listed on the Toronto Stock Exchange. The dual share structure allows the founding Southern family to retain control. Both classes of shares tend to trade at very similar prices but only a handful of voting shares are typically traded each day. In general, as a smaller investor, I would have a preference for the voting shares even if they are relatively illiquid. However, much greater care and patience is required when trading illiquid stocks. Investors with little experience may be better off sticking to ATCOís non-voting shares.

Before rushing to buy any stock, it is important to remember that the vast majority of investors should avoid overly concentrated portfolios. One stock does not a portfolio make! In addition, individual concerns may mitigate against any particular security and investors should discuss any potential trade with their investment advisor.

Additional Resources:
. The Intelligent Investor, Revised Edition with Jason Zweig (ISBN: 0060555661)
. The Intelligent Investor, 4th Edition (ISBN: 0060155477)
. Graham Stocks in Short Supply (Canadian MoneySaver, Nov/Dec 2003)

Update

Since this article was first published in March 2004, ATCO split its stock 2-for-1 on August 25, 2005.

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