Allan Robinson

What are we looking for?

Today we are looking for some of the most undervalued materials companies that are capable of generating superior profits. The companies include base metal mining companies, drilling service companies for the mining industry, as well as a fertilizer producer. Precious metal mining companies were excluded.

We will use a specialized Return on Capital Report managed by Matt Kacur, president of FSA Financial Science & Art Ltd., which developed and licenses the software on which the report is based. The quantitative and mathematical analysis to determine future profitability is augmented by Haywood Securities Inc. analysts. They provide the analytic or subjective assessments of companies in the screen to adjust discrepancies between the model's valuation and the current stock market price. This helps identify changes in the 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 invested in its business.

The ROC Report analyzes about 180 companies and ranks them according to their cash flow, internal rate of return.

The final analysis produces a quarter-by-quarter screen that sizes up a company's ability to generate a return on its invested capital, 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 finer details

The analysis uses a gross invested capital approach, which is based on total assets plus accumulated depreciation (capital contributed to the business), which is then adjusted for inflation (the GDP deflator) before short-term liabilities are deducted. A more conventional cash flow calculation is then made that puts debt and equity on an equal footing by adjusting the operating profit by a normalized tax rate.

The return is based on the present value of the cash flow over the estimated life cycle of the assets.

How has the report performed?

The report generates two portfolios, one small capitalization and the other large cap. Each portfolio is a list of 20 to 30 companies. Since inception in early 2003, the small-cap portfolio has generated an annualized rate of return of 19.8 per cent, while the large-cap portfolio, which started a year later, has an annual return of 8.1 per cent. Both have outperformed their comparative indexes on the S&P/TSX.

What we found

The stock market has had a great rally, but there's still a lot of upside left based on the Return on Capital Report analysis for these materials companies.