2 ’Best of the Best’ Canadian Picks

09/21/2011 9:30 am EST

Focus: GLOBAL

Roy Ward

Chief Analyst, Cabot Benjamin Graham Value Investor

During the past four years, I’ve been intrigued by Canada’s cities, farms, mountains, rivers and lakes as well as its culture, prosperity and way of life…and its economy and stocks are very attractive as well, writes J. Royden Ward of Cabot Benjamin Graham Value Letter.

The old saying: "When the US sneezes, Canada catches pneumonia" isn’t true.

Certainly the Canadian economy follows in the footsteps of the US economy, but the economic volatility of the economy in Canada seems considerably less than that of the US. Canada avoided the financial crisis that hit the US three years ago because Canadian banks were not allowed to lower their lending standards, and they were required to retain their conservative investments.

The Canadian economy performed much better than the US economy and many foreign economies during the past three years. In fact, the Canadian economy had the smallest downturn during the recent global recession of any of the G7 countries: the United States, Canada, France, Germany, Italy, the United Kingdom, and Japan.

As of the end of the second quarter, Canada is the only country in the G7 to achieve record-high gross domestic product (GDP) levels in 2011. Canada’s economy has risen more than 8% during the past eight quarters.

Why? The banking sector is healthy, prices for new homes have risen for 18 consecutive months, and high prices for precious metals are helping the country’s huge mining industry.

Canada has three stock exchanges. The Toronto Stock Exchange (TSX) is the largest, although the New York Stock Exchange is 18 times the size of the TSX in terms of dollar volume.

The Toronto Stock Exchange Index, which is somewhat over-weighted in natural resource and bank stocks, outperformed the S&P 500 in 2006, 2007, 2008, 2009, 2010, and also thus far in 2011. Since the end of 2005, the TSX is up 8.1% compared to a decline of 8.9% for the S&P 500.

The current price-to-earnings (P/E) ratio for the TSX is close to 20, but gold and mining stocks tend to sell at high P/Es and skew the ratio higher.

During the past 15 months, I have recommended four Canadian stocks: Canadian Pacific Railway (CP), Gildan Activewear (GIL), Lululemon Athletica (LULU) and Silver Wheaton (SLW). All have performed very well despite the recent gyrations in the stock markets around the world.

In addition, I have recommended other Canadian stocks, such as Magna International (MGA) and Tim Hortons (THI), which have also performed very well during the past 16 months. In all, my Canadian recommendations are up 54%, compared to a minuscule 2% gain for the S&P 500.

I continue to think Canadian stocks provide an excellent opportunity to find undervalued stocks with excellent appreciation potential. And the August stock decline has created many new buying opportunities. I strongly recommend that investors take advantage of the current low prices and buy undervalued Canadian stocks.

I screened my Benjamin Graham database to find undervalued Canadian companies with rapidly growing earnings and strong balance sheets. I believe the two companies recommended below offer excellent appreciation potential during the next two to three years.

Canadian National Railway (CNI)
Based in Montreal, CNR operates Canada’s largest railroad system covering Canada from east to west and the central US south to the Gulf of Mexico.

Canadian National Railway is the most efficient rail operator in North America, with high profits and low costs. The company hauls a wide variety of goods, including forest products, intermodal shipping containers, farm products, petroleum, and chemicals.

Canadian National’s $1.7 billion capital improvement program to expand port facilities, add track, and purchase freight cars and fuel-efficient locomotives will help earnings roll along at a 13% clip during the next four years.

The giant expansion of Canadian National’s port facilities at Prince Rupert, British Columbia, is providing a more efficient rail leg for shipping intermodal containers from Asia to North America’s Midwest.

We believe revenues will rise 11% and earnings per share (EPS) will increase 18% during the next 12 months. The persistent housing market slump in the US has slowed forest product shipments, but all other segments of Canadian National’s business are healthy and growing.

CNI currently trades at a reasonable 12.5 times our forward 12-month EPS estimate of $5.60, with a dividend yield of 2%. CNI is a solid long-term investment.

Potash Corp. (POT)
Based in Saskatoon, Saskatchewan, this is obviously a leading producer of potash, nitrogen, and phosphate fertilizers. And nutrient-depleted and neglected soil will require increasing amounts of fertilizer during the next several years.

POT suffered from weak demand and low fertilizer prices in 2009. However, critical demand for food in places like China and Africa will require more and more fertilizer to maximize crop production.

Potash is expanding. The company spent $7.5 billion to enlarge its Saskatchewan and New Brunswick facilities, which will boost fertilizer production more than 50% by 2015.

Larger global grain crops are currently boosting demand, as evidenced by Potash’s rapid growth during the past six quarters. Sales increased an impressive 74% and EPS soared 85% during the quarter ended 6/30/11.

Higher fertilizer prices and lower costs are creating an ideal business environment for the company. We expect strong sales and EPS growth to continue during the next several years as well.

Potash shares sell at a reasonable 13.7 times forward 12-month EPS. The company pays a small quarterly dividend, which yields 0.5%. Potash is a rapidly growing company at a bargain price.

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