What are we looking for?
Small-cap stocks with staying power.
The screen
Year to date, the S&P/TSX composite total return index is up 11.8 per cent; the S&P/TSX small-cap composite total return index is up a whopping 31.2 per cent. Although the returns look attractive, much of this is driven by a rally in commodity and materials prices, which as we know can be fairly volatile.
To temper this, I've created a screen that looks within the small-cap index, focusing on companies that have a consistent history of growing earnings, and are not overly leveraged. The strategy ranks stocks on the following factors:
- Earnings variability (a measure of earnings consistency; companies exhibiting consistent earnings will have a lower number, and are preferred);
- Trailing return on equity;
- Five-year normalized earnings-per-share growth (the growth rate of EPS over five years);
- Nine-month price change;
- Quarterly earnings momentum (latest four quarters of reported earnings compared with the same figure one quarter ago).
To qualify, stocks must have a market cap greater than $250-million, and must have a debt-to-equity ratio that is less than the median ratio of the sector to which the stock belongs. Only stocks in the S&P/TSX small-cap index were considered.
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 CPMS to back-test the strategy from May, 1999, to June, 2016. During this process, 10 stocks were purchased and equally weighted with a maximum of three stocks a sector. Stocks would be sold if they fell outside the top 50 per cent of the ranked universe, or if the stocks price dropped by more than 15 per cent over three months.
Over this period, the strategy produced an annualized total return of 11 per cent while the BMO Nesbitt Burns small-cap total return index advanced 7.3 per cent. The 10 stocks that qualify today are listed in the accompanying table.
As always, 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.