What are we looking for?
Quality growth in lesser-known small- and mid-caps in Canada.
The screen
Right on the heels of 2016, when the S&P/TSX small-cap total return index gained 38.5 per cent, the start to 2017 looks positive as well, with the small-cap index up 5.3 per cent (versus 3.75 per cent for the S&P/TSX 60 total return index). With this in mind, I created a strategy that looks for small- to mid-cap firms that are not part of the S&P/TSX composite index and ranks them according to:
- Five-year earnings growth, five-year cash-flow growth and five-year sales growth (for each of these measures, we use a statistical method called linear regression to calculate the rate of change over a five-year period);
- Earnings variability (a proprietary CPMS calculation that measures the consistency of a company’s earnings, lower figures preferred);
- Five-year historical beta (remember, a company with a beta less than one has historically moved less than the benchmark in trending markets. Here, lower beta is preferred).
To qualify, stocks must have an average monthly value of shares traded of $2-million or greater (this figure represents the top two-thirds of companies in the Morningstar CPMS Canadian database). To ensure we avoid any overleveraged companies, we only include names that have a debt-to-equity ratio that is equal to or lower than their sector's median.
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 back-test this strategy from May, 1999, to January, 2017. During this process, a maximum of 15 stocks were purchased with a maximum of four stocks per sector. Stocks are sold if their rank falls below the top 35 per cent of the universe. Over this period, the strategy produced an annualized total return of 12.4 per cent. Today, stocks that qualify for purchase into the strategy are listed in the accompanying table.
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.