What are we looking for?
Companies in the S&P 500 showing good returns on equity and high relative reinvestment rates.
The screen
In yesterday's Number Cruncher, I used Morningstar CPMS to help understand the factors that contributed to the best-performing stocks in the S&P/TSX composite over the first quarter of 2017. Today, I repeat the same exercise for the U.S. market.
Using a theoretical portfolio of the top 50 performing stocks in the S&P 500 over the first quarter, I determined that this portfolio on aggregate showed high return on total assets, high return on equity, high reinvestment rates relative to their own sector and good quarterly earnings momentum relative to the broader S&P 500 index at the start of the quarter. To understand whether these same factors provided value over a longer period, I built a strategy that ranks stocks on these same factors with a few added modifications. The strategy ranks stocks on the best mix of:
- Latest return on total assets;
- Trailing return on equity;
- Reinvestment rate relative to the sector median (in the table, a value of 26.8 per cent shows that the company has a reinvestment rate that is 26.8 per cent higher than the median reinvestment rate of the sector to which the stock belongs – higher figures are preferred here);
- Quarterly earnings momentum (latest four quarters of reported earnings per share compared with the same number four quarters ago);
- Earnings surprise (percentage difference between actual and expected earnings for the latest reported quarter).
To qualify, stocks must be part of the S&P 500 total return index.
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to backtest this strategy from December 1993, to March, 2017. During this process, a maximum of 15 stocks were purchased with a maximum of four stocks an economic sector. Stocks are sold if their rank fell below the top 30 per cent of the universe or if consensus estimate for EPS dropped by more then 10 per cent over the trailing three months. When sold, the positions were replaced with the highest-ranked stocks not already owned in the portfolio, keeping in mind the aforementioned sector limits.
Over this period, the strategy produced an annualized total return of 11.5 per cent while the S&P 500 total return index advanced 9.4 per cent. Stocks that qualify for purchase into the strategy today are listed in the accompanying table.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.
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