Craig McGee is a senior consultant at Morningstar Canada.
What we’re looking for?
I used CPMS to search for companies with a sustainable competitive advantage based on our analysts’ in-depth analysis. They also needed to show strong profitability and be trading at relatively low valuations.
Specifically, I ranked the CPMS U.S. database for the top 20 stocks with the best combination of the following criteria:
- Price to sales (trailing four quarters)
- Price to earnings (trailing four quarters)
- Return on equity (trailing four quarters)
Qualifying stocks must have at least a narrow economic moat (which describes the strength of a firm’s competitive position, due to advantages arising from high customer-switching costs, low-cost production, intangible assets, network effects or efficient scale). Each stock’s P/E must also be less than its historical average, and its ROE must be greater than its historical average.
More about Morningstar
Morningstar 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 over 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
To test how repeatable and effective this approach would have been, I used the CPMS backtest to pick an initial portfolio of 20 equally weighted stocks using the above criteria back on April 30, 2004. Stocks were then reranked monthly and would be replaced if they fell outside of the top 50 per cent. Stocks would also be sold if they were no longer deemed to have a narrow or wide economic moat.
Since inception, this approach would have generated an annualized total return of 19.0 per cent while the S&P 500 Total Return Index put up an annualized return of 7.6 per cent. Over that time period, the model outperformed the index in 74 per cent of quarters (and 85 per cent of quarters when the index was down). Over the year ended Feb. 28, 2014, the strategy posted a total return of 50.2 per cent versus 25.4 per cent for the index.