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Twenty smaller undervalued stocks with big potential Add to ...

Craig McGee is a senior consultant at Morningstar Canada.

What we are looking for

Value approaches appear to be in style this year, as investors have been looking for unloved and undervalued options. I wanted to highlight some smaller stocks, for those with a little more appetite for risk.

I searched the CPMS Canadian database for the 20 highest-ranking smaller stocks based on the best combination of the following attributes:

  • Price to earnings;
  • Price to cash flow;
  • Price to sales;
  • Price to book value;
  • Revision of the upcoming year’s consensus earnings estimate over the past three months.

The largest one-third based on market capitalization was excluded to focus on companies with a market cap of less than $1-billion, and the bottom quarter based on average volume was excluded to remove the most illiquid names. Results were finally filtered to show only those stocks with flat or positive estimate revisions.

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

Using CPMS, I back-tested the strategy to apply the same rules-based approach beginning Dec. 31, 1985. An initial portfolio of 20 stocks was equally weighted and each month the database was re-ranked. Stocks would be held until they fell outside of the top 40 per cent or if their three-month estimate revision was less than minus 15 per cent.

Over the full time period, the strategy generated an annualized total return of 20.0 per cent versus 8.5 per cent for the S&P/TSX composite total return index. In the 12 months ended March 31, 2014, the strategy posted a return of 31.1 per cent, while the benchmark came in with 16.0 per cent.

Canadian smaller cap value stocks

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