October 24, 2014 Comments

On Friday, the S&P 500 was up 0.7% and Toronto was up 0.4%

Agrium was up 7.5% on news that an activist investor now owned a stake around 6%. I am not sure that this is a good reason for the stock to go up. But the market seems to believe that the activist will generate some change that will drive the earnings up or otherwise add value to the shares.

FirstService was up 4.4% although it will not release earnings until next week.

Anatomy of a Winning Stock

Canadian Tire reached a new high today and closed over $125.

Three years ago in the Fall of 2011 Canadian Tire was trading around $56 to $65. It was under $60 from mid-July through tot the end of October 2011. So the stock is up over 100% from the prevailing price three years ago.

So what explains that?

We can divide the gain into two components:

1. Gains in its earnings per share and resulting gains in its book value per share.

2. Gains in its multiple as in the P/E ratio and Price to book ratio which in turn reflect many things including the outlook for earnings.

Canadian Tire’s earnings per share since the Fall of 2011 are up 42%. And the book value per share is up 28%. So, 42% of the rise in the stock can be accounted for by the rise in achieved earnings.

If we are conservative and use $62.50 for the share price in the Fall of then the P/E ratio was an attractive 12.4 times earnings (and at $56 it was only 11.1). Today the P/E ratio is 17.4 times.

So the P/E ratio is up by 40% or more (depending on which price we use from 2011)

If we compound a 42% increase in earnings and a 40% increase in the P/E ratio we get an increase of 1.42 times 1.40 = 1.99 or not coincidently an increase of about 100%.

So… Canadian Tire has risen 100% from about $62.50 in the fall of 2011 to $125 today. This is explained about equally by the increase in its achieved trailing earnings and an increase in the P/E ratio.

In the Fall of 2011 Canadian Tire looked like an obvious bargain and we said so at the time and I made it over 20% of my own portfolio. The stock was basically pricing in a lot fear including what Target would do to it and pessimism about the economy and markets in general.

Today, Canadian Tire is not a screaming bargain but at 17.4 times earnings and just under 2 times book value it is also not all that expensive. We last rated it only a (lower) Buy at $115.51. Possibly I have been too conservative with this company as it has continued to do very well. But at some point P/E ratios can also come down.

A small drop in earnings combined with a small drop in the P/E ratio can pull any stock down say 20% quite quickly. I have tried to be conservative and assumed that the P/E ratio for Canadian Tire will be in the range of 14 after my assumed five year holding period. Perhaps I should assume more like 16. I also assumed a conservative earnings growth rate of no more than 7.5% per year. By using higher growth rates and a higher P/E ratio it is possible to push the apparent value of a stock to just about any number desired within reason. I try to be conservative without being too conservative (in which case everything looks too expensive).

The ideal scenario is when we find stocks of high quality companies that appear to be obvious bargains even assuming quite low earnings growth and assuming a conservatively low P/E ratio. In 2009 and in 2011 we had a number of stocks like that. Today we don’t have anything quite that attractive on the list.

Melcor is perhaps our best obvious bargain though it can be quite cyclical. Basically to the extent some of our picks look like bargains (our banking picks come to mind) they also come with risk. Then again the market and even Canadian Tire was perceived as quite risky in 2011 which was why the bargains existed.

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