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Picking TSX 60's best eggs for the basket

dparkinson@globeandmail.com

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One of the big complaints about index-based investing is that when you buy an index, you're indiscriminately buying a basket of stocks regardless of the relative quality of each egg that populates it. A few rotten ones can taint an otherwise well-prepared omelette.

That's why the chefs in the kitchens of Standard & Poor's have whipped up a new concoction that aims to weed out the weakest stocks in Canada's S&P/TSX 60 blue-chip index and largely toss them out of the mix - while adding an extra dash of the most tasty ingredients in the index.

It's called the S&P/TSX 60 130/30 Strategy Index, unveiled yesterday.

S&P/TSX 60 - WITH A TWIST

The new index - upon which a new exchange-traded fund from Horizon AlphaPro will be based - takes the existing S&P/TSX composite index (in which stocks are weighted based on market capitalization) and assesses the stocks based on a set of fundamental and quantitative criteria, to identify which ones are more likely to be outperformers and which are more likely to be underperformers.

The criteria include analysts' average recommendations, earnings yield, dividend yield and S&P Quality Ranking, which is an indicator of earnings and dividend stability.

S&P takes the top-10 highest-ranked stocks under these criteria and boosts their weightings in the index by 3 percentage points, and takes the bottom-10 stocks and reduces their weightings by 3 percentage points. (Since most of the stocks on the S&P/TSX 60 have an index weighting of less than 3 per cent to start with, this means that the 130/30 index will take on short positions in most stocks in the underweight basket in order to lower their weightings by the full 3 percentage points.)

Effectively, this means the index is taking the 10 strongest investment ideas in Canadian blue-chips - based on relatively objective criteria - and loading up on them, while taking the 10 weakest links and either scaling back on them or actually shorting them.

DIGGING UP THE VALUE

S&P's back-testing of the new index shows that it would have outperformed the S&P/TSX 60 by 10 percentage points over the past year. Its annualized returns would have topped the S&P/TSX 60 by 7 per cent over the past three years and 11 per cent over the past five years.

Of course, any time you're making value judgments on stocks - and, especially, when you're actually shorting them - there's elevated risk and volatility over the standard index.

But this strategy does provide investors with a handy way to avoid one of the pitfalls of standard indexes - where the more a stock gains, the more weight it takes on in your portfolio. Some of the heaviest-weighted holdings can end up being the most overvalued, while the bargains end up under-represented. This strategy turns that on its ear - the heavier weightings will tend to go to high-quality yet undervalued stocks.

And regardless of whether you choose to actually invest in the AlphaPro ETF, or build a portfolio mimicking the 130/30 index, the index will provide all investors with handy lists of Canadian blue-chips that look attractive and unattractive, based on some pretty well-established criteria for rating stocks.

Keep in mind that a stock's presence on the overweight or underweight list is not necessarily a judgment on the quality of the stock, or the company. Yes, it is, in part, an assessment of the underlying fundamental quality of the investment, but it largely reflects relative valuation.

A glance at the underweight list proves this point. It contains several stocks that have, indeed, been market favourites in recent months, notably SNC-Lavalin and the high-flying gold sector. But the gains they have already achieved appear to have made them less attractive going forward, in terms of their valuations and potential for further gains, relative to the rest of the index.

Logic suggests that the next bargains will be found elsewhere - and the new index's rating criteria bear that out.

OVERWEIGHT/UNDERWEIGHT STOCKS

S&P/TSX 60 130/30 STRATEGY INDEX

Overweight Underweight
Company Ticker Company Ticker
Bank of Nova ScotiaBNSAgnico Eagle Mines LtdAEM
Canadian Oil Sands TrustCOS.UBarrick Gold Corp.ABX
Husky Energy Inc.HSEEldorado Gold Corp.ELD
Inmet Mining Corp.IMNFirst Quantum MineralsFM
National Bank of CanadaNAGroupe Aeroplan Inc.AER
Nexen Inc.NXYIamgold Corp.IMG
Penn West Energy TrustPWT.UMagna InternationalMG.A
Shaw CommunicationsSJR.BResearch In Motion RIM
Sun Life FinancialSLFRogers CommunicationsRCI.B
Yellow Pages Income FundYLO.USNC-Lavalin GroupSNC
Source: Standard & Poor's

© 2007 The Globe and Mail. All rights reserved.

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