What are we looking for?
Non-energy stocks with upward momentum.
As the Canadian energy sector continues to suffer through the oversupply of crude, investors looking for a sector rotation will quickly realize that aside from the energy and (to a lesser extent) the materials sector, Canadian markets have seen upward price momentum in several other sectors.
In last week's article, I wrote about a low-beta strategy that was built to be less sensitive to general market movements. This week's strategy will behave quite the opposite and will react aggressively to market movements with an overall strategy beta greater than one. (Remember that the beta of an underlying benchmark – in this case the S&P/TSX composite index – is equal to one. During market movements upward or downward, portfolios with beta greater than one will move more than the market, while portfolios with beta less than one will move less than market.)
This week, I looked at a modified version of the CPMS "Aggressive 10" strategy that captures names with positive earnings and price momentum. Specifically, this strategy seeks stocks with the best combination of the following factors:
– positive three-month estimate revisions;
– positive quarterly earnings momentum based on four quarters of reported earnings (please note that even though Intertape Polymer has a negative quarterly earnings momentum, it is still listed as a top ranked stock due to a combination of the other factors);
– positive quarterly earnings surprise;
– positive price changes in the three-, six-, nine- and 12-month time frames.
Qualifying names will also have positive consensus earnings-per-share estimates for the current fiscal year. The original strategy was modified to exclude companies in the energy sector and companies with a market capitalization less than $675-million.
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 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 beginning Dec. 31, 1991. During this process, the top 10 ranked stocks passing all criteria were purchased and equally weighted. Stocks would be sold if they fell outside the top 40 per cent of the database, or if the current year median EPS estimate turned negative. Recall that energy names were excluded during the full test period.
Over the 23-year backtest period, the strategy produced an annualized return of 20.5 per cent, while the S&P/TSX composite index returned 8.9 per cent. Average annual turnover was 113 per cent. (Turnover represents the percentage of stocks that are traded in a given year. So for a 10-stock portfolio, there will be roughly 11 trades per year.) As expected, over this period, the returns were more volatile than the market with a strategy beta of 1.2 measured over the full test period. During quarters where the market moved up, this strategy outperformed 70 per cent of the time. During quarters where the market moved down, this strategy outperformed 55 per cent of the time.
Investors are always advised to conduct independent research before purchasing stocks listed here.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.