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What are we looking for?

Stocks that may be oversold.

The last month has been a generally dismal time for markets as worries grow over the impending U.S. fiscal cliff, slowing corporate earnings and a euro zone recession. With the help of Craig McGee, senior consultant at Morningstar Canada, we set out to find stocks where pessimism may be outrunning reality.

How we did it

Mr. McGee delved into the Morningstar CPMS database to find the 20 Canadian stocks that are the cheapest on four classic measures of value – price-to-earnings, price-to-cash-flow, price-to-book and price-to-sales multiples – and that are also rising in analysts' estimation.

To qualify, stocks must have had a positive change in analysts' consensus earnings estimates over the past 90 days; they must also have average trading volume in the top third of the database. No more than five stocks per sector were allowed.

More about Morningstar

Morningstar Inc. provides independent investment research in North America, Europe, Australia and Asia.

Its investment 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.

What we found

This strategy is the basis for the Morningstar Canadian Value Index, which tracks 30 names instead of the 20 here. To find out how a 20-stock approach would have fared, Mr. McGee performed a backward-looking test.

He assumed a hypothetical investor had picked 20 stocks according to the principles above on Dec. 31, 1993, and refreshed his portfolio every three months to Sept. 30, 2012. The investor sold whenever a stock in the portfolio fell outside of the top 40 per cent of the CPMS Canadian database based on the criteria above.

This hypothetical investor would have generated an annualized return of 17.6 per cent, far ahead of the S&P/TSX Composite Total Return Index, which had an 8.1 per cent return over the same period.

Those are tempting numbers. Just remember that strategies don't always perform in the future the way they have in the past. Do your own research before buying any of the stocks listed here.

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