Building Block Stocks with Strong Balance Sheets

As the Canadian economy begins to re-open, we are seeing more demand for natural resources and infrastructure that make up the basic building blocks of our economy. As a result, sectors like industrials, energy and basic materials are likely to see positive demand tailwinds. We are also seeing improved economics in the oil and gas sector as we discuss in a recent blog post. In addition, these are sectors that are likely to continue benefiting from supply-chain bottlenecks given where they are in the economic value-chain and even benefit from inflation due to their commodity-linked nature.

For this month’s stock screener we focus on companies in the industrial, energy and basic materials sectors with strong balance sheets and a market capitalization of over $100 million. The point of this is to focus on companies that are more likely to come out as winners in an economic recovery due to the flexibility of their balance sheets and ability to capitalize on demand. We also discuss some notable companies we found in the list below.

Here are the balance sheet criteria we used:

Current Ratio > 1

This initial screen is meant to identify companies with a healthy working capital position. A company with a current ratio of less than 1 means short-term liabilities are greater than short-term assets. This may leave a company in a more restrictive position when it comes to making short-term purchases to expand inventory when demand comes flowing through, potentially forcing an operator to take on more debt to meet that demand. Companies with a higher current ratio are put under less stress and can more easily capitalize on short-term opportunities.

Debt to equity (D/E) <100%

While we typically prefer companies with an even lower D/E ratio (i.e. 50% or lower), we have kept in mind here that these sectors typically have higher capital expenditures and in turn, typically run on higher debt loads, so we think it makes sense to have a more lenient standard here. At the same time, a capital-intensive company with a low D/E implies great potential flexibility on the balance sheet. 

Net debt to EBITDA

This is a metric we like to use to measure a company’s cash flows compared to its debt (after subtracting all available cash). We find EBITDA is often a ‘good enough’ proxy for operating cash flows. It is insightful because it gives us an idea of how many years of cash flow (or EBITDA) it would take for a company to completely pay off its debt at present. For example, a ratio of 2x means it would take two years of those same cash flows for the company to fully pay off its debt (if we assume cash flows are not reinvested into the company and dividends are not paid out). To us, a ratio of less than 2x usually means a company’s debt load is not crippling to the company’s ability to grow, increase the dividend or even take on more debt. 

We find this metric especially relevant to companies in the industries we have focused on for this screen, as they tend to have higher capex needs (maintenance of equipment, machinery, expansion of production etc) and it is not uncommon for companies in these industries to pay a dividend. 

Commodity risks

Certainly, these sectors are quite cyclical and as mentioned above, many are commodity-linked. This can mean potential headwinds at the sign of inflation slowing down or even a rise in interest rates or the US dollar given their historical inverse correlation to commodities. We would also exert some caution in the near term on names in the forestry industry with lumber prices cooling off. 

Here is the screen: