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The Top 200 Canadian Stocks for 2008

For most of us, picking stocks is as tricky as ordering a seven-course dinner at a swank new restaurant. We know that lots of items on the menu sound appetizing, but that's where our knowledge ends.

Rather than simply point and hope, smart diners look for a restaurant reviewer who can provide an expert opinion on the restaurant's offerings. To provide smart investors with a similar scouting report, we're pleased to present you with our candid take on all of Canada's largest stocks.

This is the fourth annual MoneySense Top 200 and we are pleased to say that connoisseurs have dined out very well on our past reviews. In each previous edition, we picked what we call All-Around All-Stars . stocks that score well on both our growth and value tests. Our All-Stars have consistently produced double-digit returns. The 2006 team achieved average returns of 16%, while the 2005 All-Stars gained 38%, and the 2004 squad soared an amazing 58%. An RRSP investor who put $10,000 into the 2004 picks and rolled his or her gains into the new All-Star team each subsequent year would now have $25,200. And those results don't include the generous dividends that we picked up along the way.

As you might imagine, we're delighted with our results. We want to stress, though, that picking stocks is an uncertain business. We don't expect to deliver double-digit returns all of the time. Indeed, we fully expect to lose money some years. Our 2006 All-Stars demonstrate how unpredictable the market can be. Our best pick, IPSCO, booked a 71% return before it was taken over by Swedish steel conglomerate SSAB. Our worst pick, Kingsway Financial, fell 23%, as the galloping loonie pummeled the value of the insurance company's U.S. operations. Smart investors should diversify their holdings and do their own research before arriving at a decision to buy.

To help you in your research, we've worked hard to produce a rating system that's easy to use, logical, and appealing to all types of investors. We think the Top 200 provides you with a more objective, more insightful look at large Canadian stocks than you're likely to find from any other single source. If you're looking for a sensible take on any large Canadian stock, you'll find the Top 200 to be an invaluable way to generate promising investment ideas.

To arrive at the Top 200, we begin by identifying the largest 200 companies in Canada by net sales. Using data supplied from Bloomberg, we evaluate each stock, first for its attractiveness as a value investment, then on its appeal as a growth investment. (Value investors like stocks that trade at low multiples of book value and pay juicy dividends. Growth investors like companies that are rapidly expanding their revenues and earnings.) Our value and growth screens employ sophisticated measures of financial merit, but in the end we reduce everything about a stock to two grades - one for value appeal, one for growth potential.

The grades work just like they did back when you were in school. Top-of-the-class stocks earn an A. Solid but uninspired students get by with a B or a C grade. Disappointments get sent home with a D or even an F.

Only a select group of stocks - those that manage to achieve at least one A and one B on both the value and the growth tests - qualify for our All-Around All-Stars. A mere seven stocks make the grade this year.

The value test

Value investors like solid stocks selling at low prices, so we begin by looking for stocks with low price-to-book value ratios (P/B). This number compares the market value of the company to how much money you could raise by selling off all the company's assets (at their balance sheet prices) and paying off all the firm's debts. You can think of a low price-to-book value ratio as assurance that you're not paying a lot more for a stock than its ingredients are probably worth. To get top value marks in our rating system, a stock has to possess a low price-to-book-value ratio compared to the market and also compared to its peers within the same industry.

Other factors matter too, of course. Good companies produce profits, so we award higher scores to firms that have positive price-to-earnings ratios over the past year (this backward-looking figure is known as the trailing P/E ratio). We also reward a company if industry analysts expect it to have a positive P/E over the next year (this number is known as the forward P/E ratio).

Because we like to have a little spending money in our wallets, we award extra marks to dividend-paying stocks. And to ensure a company won't be sunk by excessive debt, we penalize spendthrift companies living on credit. We award the best grades to firms with low leverage ratios (defined as the ratio of assets to stockholder's equity) compared to their peers. Finally, we combine all these factors into a single value grade. Only 18 out of 200 stocks got an A this year.

The growth test

The first mark of a good growth stock is, not surprisingly, growth. We start by awarding high marks to any stock that has achieved robust earnings per-share and sales-per-share growth over the past five years. We also want to be sure that the market is taking note of this improving situation, so we hand out additional marks to stocks with strongly rising share prices. In particular, we favor stocks that have provided healthy total returns over the past year.

As great as growth is, we don't want to buy into fads, so we hedge our bets by checking out each stock's return on equity (ROE). This vital statistic measures how much a firm is earning compared to the amount that shareholders have invested. It is an important indicator of the quality of a business. Only those stocks with strong returns on equity compared to industry norms earn our top marks.

Finally, since no one wants to be the last buyer in a bubble, we examine each stock's price-to-sales ratio (P/S). This ratio measures the stock's price in comparison to the company's net sales. We figure that low to moderate price-to-sales ratios indicate stocks that are reasonably priced, so we award them extra marks. In contrast, firms with high price-to-sales ratios may be "concept" stocks that have generated a lot of hype and excitement, but little in the way of actual sales.

Putting all these growth and quality indicators together, we arrive at a final growth grade. Only 18 out of 200 stocks earn an A this year.

The all-star team

As we mentioned above, a mere seven stocks earn at least one A and a B on both our value and growth tests. The only returning All-Star from last year's team is E-L Financial (TSX: ELF). The Toronto insurance company still gets an A for value, but its growth ranking slipped to a B after its price momentum flagged over the summer.

New to the All-Star list is Empire Company (TSX: EMP.A) of Stellarton, N.S. You probably know the food and real estate conglomerate for its Sobeys grocery stores. Another new All-Star, Sherritt International (TSX: S) of Toronto, is a diversified natural resource company that is best known for its operations in Cuba. Keep in mind that the U.S. frowns on firms doing business with Castro. Sherritt could feel the heat if Washington decides to get tough with the Caribbean nation. Such political questions are something that a stock screen like the Top 200 can't take into account.

Linamar (TSX: LNR), the auto-parts maker based in Guelph, Ont., is yet another new name on the All-Star list. It won its place on our list by growing its earnings and sales by double-digit amounts over the last five years. Growing even faster is Methanex (TSX: MX) of Vancouver. It has boosted its earnings-per-share by 57% annually over the last five years. Its primary business is making methanol, a form of alcohol used as an ingredient in plastics, plywood and paint. Who knew the stuff could be so profitable?

Our final two All-Around All-Stars are a study in contrasts. TransCanada (TSX: TRP) the giant pipeline company, is the classic widows-and-orphans stock. The Calgary firm may appeal to conservative investors.

On the other hand, Winpak (TSX: WPK), a Winnipeg food-packaging firm, is by far our smallest All-Star stock. It doesn't trade very frequently and is best suited for more adventurous investors. Before buying any stock, you should make sure that its situation hasn't changed in some important way. Read the firm's latest press releases and regulatory filings. Scan newspaper stories to make sure you've sussed out all the important developments and breaking news. Like a good restaurant reviewer, we've done our best to evaluate the offerings on the menu, but you should arrive at your own decision before loading up your plate.

From the December/January 2008 issue

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