In light of recent market volatility and valuation re-ratings of over the last year or so, we thought it would be prudent to run a screen to identify potential mispricing in valuations of quality stocks. We believe in the long-run, markets tend to get valuations of companies right, but in the short-term, changes in sentiment, market environments and increased uncertainty can result in overdone sell offs. With broad markets down year-to-date, we think this is a good time to revisit quality stocks trading at historically low valuations. In this month’s stock screener, we identify 25 Canadian stocks that match our screening criteria.

With markets remaining strong in 2020 and 2021 despite a pandemic-induced recession, the recent market sell-off has resulted in many companies seeing their valuation multiples make a ‘round trip’, so to speak.

Below, we identify companies that are trading at valuation multiples less than levels seen just before the COVID-19 pandemic. This should provide a benchmark for ‘normal’ valuations. Of course, the limitation here is that valuations in December 2019 were under different circumstances (interest rate expectations, GDP growth, inflation etc). However, we think this provides a good reference point for investors shopping for companies with healthy balance sheets and good growth despite the pandemic. The idea here is that there could be some ‘mean-reversion’ to this level or higher while acquiring a quality company at a discount to a historical benchmark.

We also include a secondary column that indicates whether or not a company’s multiple is below its ‘March 2020 multiple’ as this generally reflects a recent historical bottom which most equities have recovered from quite quickly. We think this could be another area to explore for potential heavily mispriced names.

Below are the criteria and the reasons why we chose each:

• Market cap above $100 million:
  • Going with a market capitalization of over $100 million has been a standard for our screens. It fits our philosophy of focusing stocks that are liquid enough to receive institutional attention and are more likely to have a revenue track record and a significant enough presence in their industry than companies that are below $100 million.

• Current Forward EV/FCF below December 2019 levels
  • Why did we choose Enterprise Value to Free Cash Flows as a valuation multiple? At 5i Research, we place a lot of importance on free cash flows when evaluating a business as we believe that is what ultimately determines its long-term value. It may also provide an edge for investors looking to differentiate their search from other investors who typically focus on P/E and EV/EBITDA multiples. However, we do note that many companies whose EV/FCF is below levels of December 2019 are also below on standard multiples of P/E and EV/EBITDA.  

• Net debt to EBITDA ratio below 3x
  • With rising interest rates and higher inflation, we think companies with strong balance sheets and good cash flows are likely to be favourable for investors. The recent sell off may also make investors generally wearier of companies with negative cash flows. Companies with high debt levels may also be less favoured by investors who worry about high costs of borrowing (interest rates). High inflation also means further pressure on margins, so strong cash flows help provide a cushion and more flexibility for companies to make investments that lower operating costs (e.g., acquire technologies that will reduce labor costs).

• Five-year annual revenue growth of 10%+
  • In a ‘normal’ environment, we would consider companies that can consistently grow their revenues by 10% annually to have relatively robust growth. It also generally signals a relatively strong market presence and potentially growing market share. In today’s context, companies that have been able to maintain an average growth rate of 10% or more through a pandemic induced recession is even more impressive and could indicate a strong market position.

Readers can find the screener below:

Large-cap names

The above criteria mentioned above reflect the larger cap nature of many of the names we see above. Despite us filtering for stocks with a market cap of $100 million or greater, most of the names that came up are over $1 billion. This could mean a potential opportunity to profit from larger names both from a valuation rerating and continued support in the valuation from strong and stable fundamentals compared to smaller or riskier names. Given we have filtered for 10%+ annual revenue growth, we also think the larger cap nature of this list reflects the advantage of investing in more established market leaders, especially in times of economic uncertainty.

Some examples that are seen in our model portfolios here are Open Text (OTEX), BRP Inc (DOO), GDI Integrated Facility Services (GDI) and Canada Goose (GOOS), all of which we would view as market leaders. GDI and OTEX in particular have not stopped in acquiring smaller competitors to complement their businesses over the last two years. On the other hand, DOO and GOOS both fall into the category of names that are trading below March 2020 pandemic low multiples, which makes their valuations at these levels quite interesting.

Materials and energy

We also notice a dominance of energy and materials companies on this list. For energy, it is interesting that valuations are still below historical levels given the strength energy names have seen in recent months. We find it just as interesting that many of the names on this list that are trading below March 2020 multiples are also energy and materials companies. This could indicate more room for both sectors to run. With inflation continuing to run high, commodities and materials stocks should also continue to benefit from some near-term tailwinds. Some notable names that can be seen on this list are Nutrien (NTR), Tourmaline Oil (TOU), Agnico Eagle Mines (AEM).

As always, the names mentioned or qualified for this screen are not an endorsement or recommendation to invest. Rather, we hope this list provides a good starting point for your research and an idea generator for potential mispriced opportunities.

Knowledge pays the best dividends.

Disclaimer: The analyst(s) responsible for this report do not have a financial or other interest in securities mentioned