What are we looking for?
Dividend-paying value picks with strong earnings.
The screen
In comparison to other investment strategies, value investing has underperformed significantly in recent years in the U.S. market. Additionally, "value traps" are a real possibility with this style. (A value trap is a situation in which a stock that appears to be cheap because it is trading at low multiples, but the company is actually in trouble and the price may never recover.) But there is a way to improve the quality of the value picks by focusing on those that exhibit quality earnings, despite the low stock price. Today's CPMS strategy has a strong emphasis on value factors, but at the same time screens out stocks with concerning earnings qualities. This strategy ranks stocks based on the best combination of:
Price-to-trailing earnings (ratio of a company's latest price to its trailing four quarters of operating earnings per share. Can be interpreted as the multiple that investors are willing to pay for a firm's reported operating earnings);
- Price-to-trailing cash flow (ratio of a company’s price to its trailing four quarters of cash flow from operations);
- Three-month analyst estimate revisions (current consensus estimate for EPS versus three months ago);
- Yield on expected dividends (estimated annual dividend rate expressed as a percentage of the latest market price of the stock);
Qualifying companies have a market capitalization greater than current CPMS median, and average daily value traded of more than $24-million. They have a yield greater than 2 per cent, quarterly earnings momentum (rate of change of quarterly operating earnings per share) greater than the current CPMS median, at least three analysts providing EPS estimates for the current year for the stock and three-month estimate revisions greater than minus 5.0.
More about 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.
What we found
I used Morningstar CPMS to back-test the strategy from April, 2004, to April, 2016. During this process, 20 stocks were purchased and equally weighted. Stocks would be sold if they fell outside the top 20 per cent of the ranked universe, and if the three-month estimate revision fell below minus 15. Over this period, the strategy produced an annualized total return of 13.9 per cent while the S&P 500 total return index advanced 7.5 per cent. The top 15 stocks that qualify today are listed in the accompanying table.
As always, investors are encouraged to conduct their own research before purchasing any of the investments listed here.
Julie Michaels, MBA, is a relationship manager for CPMS at Morningstar Research Inc.