What are we looking for?
A conservative approach to stock selection with a reliable income stream.
In analyzing the behaviour of the U.S. market over the third quarter, we at CPMS saw a strong value play, which was quite different than the momentum market of the second quarter. But timing the market can prove to be a dangerous and an unprofitable game. Correctly identifying the incoming market trend and its beginning and end has proved difficult even for professional money managers. I wanted to look at a more slow-and-steady approach, which may not shoot the lights out, but provide a stable return stream with lower risk, regardless of the market environment. Today's strategy focuses on stocks that exhibit the following fundamental factors:
- Five-year beta versus S&P 500 index;
- Quarterly earnings surprise (proprietary measure of the percentage difference between actual and expected earnings);
- Earnings variability (earnings per share variability, in percentage terms, around the five-year EPS);
- Price to trailing earnings;
- Price-to-book (P/B);
- Three-month analyst estimate revisions (current consensus estimate for EPS versus three months ago);
- Expected dividend yield.
Qualifying companies have a market cap greater than $3-billion (U.S.), and average daily value traded over $25-million. They have a yield higher than 1.05 per cent; and positive last reported adjusted EPS and median EPS estimate for the current year. Their payout based on trailing dividends and EPS does not exceed 80 per cent.
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 Morningstar CPMS to back-test the strategy from December, 1993, to September, 2016. During this process, 20 stocks were purchased and equally weighted. Stocks would be sold if they fell outside the top 40 per cent of the ranked universe, the yield became zero, the payout exceeded 100 per cent, or if last reported adjusted EPS was no longer positive. Over this period, the strategy produced an annualized total return of 12.8 per cent while the S&P 500 total return index produced 9 per cent, and it beat the benchmark in nine of the past 10 years. The annualized turnover is 22 per cent. 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.