The Stock Screen

Below we have screened for companies that have a market capitalization of at least $100 million, an ROE of at least 15% and that have shown a year-over-year increase in the amount of debt issued. We have also inserted a column indicating the company’s debt to equity ratio. The idea here is that we want to find companies whose underlying business generates strong returns but have also recently issued debt at a low rate which provides low cost resources that can be reinvested into the business. 

High ROE companies tend to have responsible management 

A quality often associated with high ROE is effective and prudent management. The reassuring thing about this is that we can expect, to some degree, that a company with historically high ROE has a bit of aproven track record and will be very careful when issuing new debt. 

The ROE and interest rate spread

Companies with high ROE are in a uniquely advantageous position in that they already know how to be consistently profitable and when borrowing money at a really low cost they can invest in high returning projects and grow profits at very low risk.

Using debt to take on growth initiatives also lowers a company’s overall cost of capital. This is in comparison to if a stock issues equity (shares). Equity is generally known to have a higher cost given the higher risk associated with equity versus debt. The idea is that in order to ‘justify’ issuing equity (say 1% risk-free rate + 5% risk premium for a cost of equity of 6%), a company would have to generate a return greater than the cost of equity. With a cost of debt of say 1.25% (1% risk-free rate + 0.25% credit spread) it is a much more profitable operation and easier to achieve and repeat (lower hurdle to overcome).  

Boring but stable

At the top of the list (ranked by market cap), it is unsurprising to see stocks like Canadian National Railway (CNR), Canadian Pacific Railway (CP), Alimentation Couche-Tard Inc (ATD) and Rogers Communications (RCI), which represent very stable industries (railways, telecommunications, consumer staples) with oligopolistic structures and predictable cash flow streams. Successful companies in these industries also tend to pay a reliable dividend. Typically, these industries run on high debt so taking on a little more debt to pursue growth opportunities or (more likely) secure more liquidity during an era of COVID uncertainty, is not a bad idea.

Tech companies

It is also unsurprising to see technology companies like CGI (GIB), Open Text (OTEX) on this list given their low-capex business structures. Companies that focus on consulting and software services tend to have low overhead costs which gives more room for profit margins and in turn higher ROE. Higher profit margins also means you can reinvest in the business without borrowing, but once a business decide to borrow money, it can do so without burdening the balance sheet, which bodes well for these types of businesses. Similar to the ‘boring but stable’ companies discussed above, GIB and OTEX are also considered very well-established and ‘low growth’ stocks (despite being in tech).

5i Research Stocks

Some businesses on this list that we cover at 5i are Real Matters (REAL) and Altus Group (AIF) as well as First Service Corp (FSV) and Fiera Capital (FSZ). Interestingly the first three are all in the real estate sector, which has seen increased activity recently. REAL and AIF both have nimble business models that allow them to grow profits and maintain low costs similar to technology companies. While AIF actually sells software as a large part of the business, REAL benefits from integrating technology into its business to scale and generate network effects. You can read a detailed analysis of REAL here. We also have formal reports on the companies mentioned above in the reports section for members. 

What we find refreshing about a screen like this one is that it allows us to seek out companies that have fundamentally been managed well and combine that with a ‘leading’ indicator of taking out debt for future projects or future financial security. While we think there is merit to more popular or ‘hot’ screens such as recent all-time highs or strong revenue growth, we think a screen such as this one can be a good place to start for one trying to look where others are not looking.

Take care and remember, do your research. 

Thinking about becoming a 5i Research Member?  There is no better time to join but don't just take our word for it. Try it for free for the next month and experience all the benefits of the 5i Research membership. (And don't worry. We won't ask for your credit card upfront)

Disclosure: Employees of 5i Research involved in the research process cannot trade in Canadian traded stocks and do not hold a financial interest in Canadian companies mentioned.