What are we looking for?
How to build a better mousetrap, err, portfolio.
There are a lot of hard decisions to make when building a portfolio (i.e.: Should I buy this stock now?). There are also decisions to make about how to make decisions (Should I be looking at the value equation here or growth?). And there's also a danger that emotions will get in the way.
Crunching your way to a portfolio is one way to avoid that last pitfall - settle on a screen and then stick to your guns. But you still have to make decisions about what that screen looks like.
To give you a hand, today and tomorrow, Number Cruncher is going to look at what such a screen looks like in the real world.
We are going to rely on work done by CPMS, an equity research and portfolio analysis firm owned by Morningstar Canada, in setting up what they call their Core 20 Model Portfolio.
This screen-based portfolio is designed to highlight 10 "conservative" stocks and 10 "aggressive" stocks. Today we are going to look at the "conservative" side of things.
How does the screen work?
Jamie Hynes, senior account manager with CPMS, explained that the goal in the "Conservative 10" is to find stocks that are not as susceptible to the gyrations of the market, offer compelling relative value, deliver consistent earnings and pay a dividend.
There are seven key metrics here, with an additional three criteria that serve as deal breakers or sell indicators. The key metrics feed into a total score used to rank the 200 largest stocks in Canada.
Among the selection criteria, expected yield is the most important factor. A stock must have a yield above 1 per cent to make it into the portfolio and if it dips below 0.01 per cent it is out - there is no room for stocks that don't pay a dividend.
It also has to be a dividend the company can afford, with an 80-per-cent ratio as the highest level allowed at the time a stock is added to the portfolio. If the payout ratio subsequently gets above 100 per cent then that's a sell sign.
When it comes to earnings, CPMS wants to see low earnings volatility even as it evaluates earnings surprises and earnings per share (EPS) estimates over the last three months. In addition, trailing 12-month EPS and the median EPS need to be positive, with a break below a penny a share a sign to sell.
A low five-year beta serves to show a stock won't be too tied to the market. This factor, along with yield and EPS revisions, actually gets more weight in the final calculation for each stock.
Valuation metrics like price-to-earnings and price-to-book feed into the equation. No more than two stocks can come from the same sector.
What did we find?
This is a portfolio that lives up to its conservative name.
The dividend yield for the group averages just a shade over 3 per cent, with no troubling outliers and only one, TransCanada, anywhere near the maximum payout ratio for selection and still far below the warning level for the portfolio.
Perhaps the only thing to be worried about, for an individual running it the way CPMS runs it, is that buy and sell decisions are made daily. Even so, there's only about a 30-per-cent turnover rate for the portfolio each year however, so there's likely room to run the numbers a little less frequently and save some trading costs.
Tomorrow we'll take a look at some of the aggressive names in the Core 20 Model Portfolio and talk a little more about the overall performance of the combined strategies. Not to end on a cliffhanger, but they've done pretty well.