What are we looking for?
Amid market volatility, predictable growth with good valuations.
There is no shortage of uncertainty in the U.S. markets right now – the presidential election, fears of Brexit, lack of clarity on the Fed decision, fluctuation oil prices to name a few. The S&P 500 has been flat for the months of August and September, and S&P 500 total return index is already negative 1 per cent, quarter-to-date.
During these uncertain times, I wanted to look for stocks with strong fundamentals that exhibit more predictable growth without being overvalued.
I used CPMS to build a strategy that ranks stocks based on the best combination of:
- Forward reinvestment rate (measure of a company’s profitability – the rate at which a company is expected to reinvest earnings back into its business – a common metric of growth of a company);
- Forward price to earnings;
- Earnings variability (earnings per share variability, in percentage terms, around the five-year EPS);
- Trailing return on equity (ROE using trailing EPS);
- Quarterly earnings momentum (rate of change of quarterly operating earnings per share);
- Quarterly earnings surprise (proprietary measure of the percentage difference between actual and expected earnings);
- Price to book (P/B);
- Five-year beta against S&P 500 index;
- Price change from month-end, three and six months ago.
To ensure sufficient liquidity, the stock universe has been limited to constituents of S&P 500 index, where qualifying companies have forward P/E and P/B less than 20, beta of 1.2 or less, earnings surprise of less than 5 per cent and flat or growing quarterly earnings momentum. (A beta lower than one implies the stock's price movement is less volatile than the market index, while a beta of greater than one indicates price movement greater than the index.)
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 30 per cent of the ranked universe, if the forward P/E rose above 25, or if quarterly earnings surprise fell below negative 10 per cent.
Over this period, the strategy produced an annualized total return of 16.4 per cent while the S&P 500 total return index advanced 9.1 per cent. The annualized turnover is 40 per cent. The 12 stocks that qualify today are listed in the accompanying table.
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.