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What are we looking for?

Strong-performing Canadian stocks that are either extremely overvalued or extremely undervalued.

The screen

It is not uncommon in today's market to hear concerns that stocks are overvalued. Valuations (measured by price to earnings) have been trending higher and as such can give the impression that stocks are too expensive. The question remains: Is it still possible to find a solid portfolio of stocks in such an extreme environment?

Today I'm testing this by showcasing a strategy that looks only at stocks in the extremes of the market – either extremely high valuations or extremely low valuations. This strategy aims to create a portfolio of stocks that performs well without an excessive amount of risk despite being considered unattractive from a valuation standpoint. This strategy ranks stocks using:

  • Annual cash flow momentum (change in annual cash flow a share versus cash flow a share one year ago);
  • Quarterly earnings surprise (a proprietary measure of the difference between actual and expected quarterly earnings);
  • Percentage change in price from 12-month high (a momentum factor).

In order to qualify, stocks must have a trailing P/E that is either in the top one-sixth or bottom one-sixth of all stocks (those values today are above 30.8 and below 10.8, respectively). Stocks must also have both annual cash-flow momentum and quarterly earnings surprise with values greater than zero. Cash flow to debt must be in the top one-third of peers to avoid companies that are unable to pay their debts. Lastly, five-year beta (measures a company's sensitivity relative to changes in the benchmark – here we use the S&P/TSX composite index) must be less than 1.0.

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 this strategy from January, 2000, to June, 2017. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their rank fell below the top 50 per cent of the universe or if the company's annual cash-flow momentum or quarterly earnings surprise dropped below minus 2 per cent. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 27 per cent while the S&P/TSX composite total return index returned 6 per cent across the same period. Downside deviation (measured as the variability of negative returns) was 6.3 per cent compared with the S&P/TSX, which had a downside deviation of 9.9 per cent. Stocks that qualify for purchase into the strategy 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.

Emily Halverson-Duncan is an account manager for CPMS at Morningstar Research Inc.

Stocks in the extremes of the market

RankCompanySymbolMarket Cap ($ Mil.)Trailing P/EAnnual CF Momentum (%)Quarterly Earnings Surprise (%)Price Chg. from 12M High (%)Five-Year BetaCash Flow/DebtDividend Yield (%)
1Senvest Capital Inc.SEC-T560.22.8194.921.3-4.30.9n/c0
2West Fraser Timber Co.WFT-T4,853.609.677.18.0-2.90.91.90.4
3E-L Financial Corp.ELF-T3,360.305.630.034.2-4.70.30.70.6
4Sierra Metals Inc.SMT-T520.6n/c199.64.4-14.70.71.30
5Transcontinental Inc.TCL.A-T1,968.009.719.92.7-3.00.51.03.2
6Magna Int'l Inc.MG-T22,606.008.225.53.8-5.11.01.42.4
7Epsilon Energy Ltd.EPS-T1701,931.3060.25.5-17.80.9n/c0
8Absolute Software Corp.ABT-T312.1n/c22.82.4-6.50.5n/c4.1
9Equitable Group Inc.EQB-T891.35.855.93.5-27.50.93.21.7

Source: Morningstar Canada

n/c = not calculable. Note: P/E ratios are based on adjusted earnings values calculated by Morningstar.

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