Now’s the Time to Buy Undervalued Canadian Stocks

by J. Royden Ward on September 27, 2012
originally from Cabot Wealth Advisory

Oh Canada!

Dollarama (DOL)

Valeant Pharmaceutical (VRX)

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I’ve traveled to Canada on several occasions and been fortunate enough to visit most of the provinces that border the United States. Until my son started school in Vancouver in 2007 (he’s now graduated and teaching in Japan), I knew little about the economy of Canada and the companies that flourish there.

But during those five years, I became intrigued by Canada’s cities, farms, mountains, rivers and lakes, as well as its culture, prosperity and way of life. Canadians seem laid back and appreciative of their surroundings.

I also learned that the old saying: “When the U.S. sneezes, Canada catches pneumonia” isn’t true. Certainly, the Canadian economy follows in the footsteps of the U.S. economy, but the volatility of the Canadian economy seems considerably less than in the U.S. The financial crisis of four years ago was avoided in Canada because Canadian banks were not allowed to lower their lending standards and were required to retain their conservative investments.

The Canadian economy performed much better than the U.S. economy and many foreign economies during the Great Recession. In fact, the Canadian economy had the smallest downturn during the last four years of any G-7 country, which include the United States, Canada, France, Germany, Italy, the United Kingdom and Japan.

As of the end of the second quarter, Canada's housing market is ranked seventh best in the world. The banking sector is also healthy, and prices for precious metals are beginning to increase after falling during the past 12 months. Rising precious metals prices will help the country’s huge mining industry.

The Toronto Stock Exchange is the major stock exchange in Canada—although the New York Stock Exchange is 18 times the size of the Toronto Exchange in terms of dollar volume.

The Toronto Stock Exchange (TSX) Index, which is somewhat over-weighted in natural resource and bank stocks, outperformed the Standard & Poor’s 500 (S&P 500) Index from 2006 through 2010 but then faltered in 2011 and 2012. Indeed, the Toronto Stock Exchange Index has underperformed the S&P 500 by 22.9% from the end of 2010 to today due to the falling metals prices. But I predict the pendulum will swing in favor of the TSX soon.

For all these reasons, I believe now is an excellent time to buy undervalued Canadian stocks.

I have recommended Canadian stocks in my Cabot Benjamin Graham Value Letter on nine occasions during the past 30 months. My Canadian recommendations are up 53% compared to a minuscule 1% gain for the TSX. Am I a genius who can easily pick winning stocks? … No, but I apply my Benjamin Graham value screens to each stock to identify rapidly growing earnings and strong balance sheets … and I think now is a particularly good time to buy undervalued Canadian stocks with excellent appreciation potential.

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I believe many outstanding buying opportunities now exist among undervalued Canadian stocks. To uncover the stocks with the greatest opportunity, I screened my Benjamin Graham Database to find companies with rapidly growing earnings and strong balance sheets.

In my opinion, these two companies offer excellent appreciation potential during the next one to two years:

Dollarama (TSX: DOL 62.48) trades on the Toronto Stock Exchange only. With headquarters in Montreal, it’s the leading dollar store operator in Canada with 735 stores in all 10 provinces. In comparison, the second largest dollar store operator in Canada has only 125 stores. More than 500 of Dollarama's stores are located in Ontario and Quebec.

The company offers a broad range of general merchandise for $3 or less. Offerings include party supplies, seasonal merchandise, household products and cleaning supplies, paper and plastic products, health and beauty care products, food, novelty items and impulse products. All of Dollarama’s stores are corporate-owned and provide a consistent shopping experience.

The Canadian dollar store industry remains under-penetrated relative to the U.S. dollar store industry. On a per capita basis, there are 14,000 people per dollar store in the U.S. compared to 30,000 people per dollar store in Canada. Dollarama is opening stores rapidly to fill that dollar store void in Canada.

Dollarama’s sales increased 14% and EPS jumped 36% for the six months ended 7/31/12. Same-store sales advanced an impressive 7.7%, and sales and earnings growth has been consistent during the last several quarters. The company opened 31 new stores during the past six months.

I forecast Dollarama’s sales will increase 14% to $1.95 billion and earnings per share will rise 25% to 3.25 during the next 12 months ending 6/30/13. The price-to-earnings ratio of 19.2 is high, but if the company continues to perform well, I believe the stock can move substantially higher. The dividend was raised earlier this year and now yields 0.7%. The stock is a sleeper that very few investors are following.

The balance sheet is strong with little debt and ample cash. I recommend buying DOL at the current price.

Valeant Pharmaceuticals (NYSE: VRX 55.27), based in Mississauga, near Toronto, is an international specialty pharmaceutical company that discovers, develops, manufactures and markets a broad range of pharmaceutical products.

Valeant has developed drugs in almost all areas of medicine with a slightly higher emphasis on neurology and dermatology products. The company’s drugs include prescription as well as generic brands, and it markets about 900 pharmaceutical products globally.

The 2010 merger with Biovail tripled Valeant’s sales. The marriage has produced better than expected results featuring a vast array of products and marketing capabilities throughout the world.

Valeant’s enhanced management team is aggressively acquiring small companies with potential to immediately add earnings (commonly called accretive). The company is also expanding rapidly into emerging markets. In 2012, Valeant has already purchased a sports food supplement business in Brazil, a U.S. marketer of therapeutic products for macular degeneration and four other companies. All six companies will be accretive to Valeant’s earnings.

Valeant has acquired 50 companies during the past four years. Management recently announced its biggest deal since the merger with Biovail: Medicis Pharmaceutical for $2.4 billion. The purchase is due to be completed during the first or second quarter of 2013 and will be immediately accretive to Valeant’s earnings. In addition, Valeant expects to achieve at least $0.75 per share in annual cost synergies within the first six months after closing.

Sales will likely increase 20% and earnings per share will climb 25% during the next 12 months. My forecast does not include results from the Medicis purchase. The price-to-earnings ratio of 11.9 is a bargain, even though the company pays no dividend. The balance sheet is solid, although debt is a tad high.

Valeant is another sleeper that is lightly followed even though the company is now quite large. VRX should reach my 95.29 target price within one to two years.

I will continue to follow Dollarama, Valeant and other Canadian companies in my Cabot Benjamin Graham Value Letter. My October issue, coming soon, will focus on six new undervalued Canadian stocks. I hope you won’t miss it!

Sincerely,

J.Royden Ward
Editor of Benjamin Graham Value Letter

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