What are we looking for?
Profitable Canadian companies with growing earnings.
The screen
One of the key metrics when looking at company profitability is its return on equity, which is a measure of a company's operating earnings divided by the total shareholders' equity. It answers the question: How much profit is a company creating with the money invested by shareholders? This week, I use Morningstar CPMS to focus on this metric by ranking stocks on:
- Trailing 12 months return on equity;
- Three- and five-year average return on equity;
- Five-year EPS growth rate.
To qualify, stocks must have a monthly dollar trading volume of $3-million or above. Used as a standalone metric, ROE has often been criticized since it favours companies with small shareholder equity; these companies often choose to finance themselves by issuing debt. To circumvent this, I've also used a filter for cash-flow-to-debt (CF/D) greater than 0.2, and a debt-to-equity (D/E) ratio of less than 0.44 to avoid overly leveraged companies. The figures 0.2 and 0.44 represent the median CF/D and D/E, respectively, of all stocks in the CPMS Canadian database today.
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 CPMS to back-test the strategy from December, 1991, to March, 2016. During this process, 20 stocks were purchased and equally weighted with a maximum of five stocks a sector. Stocks would be sold if they fell outside the top 25 per cent of the ranked universe, or if three-month estimate revisions dropped by more than 15 per cent. Over this period, the strategy produced an annualized total return of 16.3 per cent while the S&P/TSX composite total return index advanced 8.2 per cent. Today, 20 stocks qualify for purchase into the strategy and 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.