What are we looking for?
U.S. companies that sell-side analysts predict will grow in the upcoming fiscal year.
The screen
Opinions are mixed on how much stock pickers should rely on sell-side analysts to determine their stock selection. In the past, analysts have been criticized because of potential biases in working at the same institution that promotes the sale of the securities they are analyzing. Although securities laws prevent sell-side analysts from speaking directly to anyone in the investment banking department, investors may still feel there is an inherent bias in the nature of the relationship. Regardless, this week I put analyst sentiment to the test by creating a strategy that focuses largely on what growth projections are from the sell-side community. The strategy ranks stocks on the following factors:
- Current year projected earnings-per-share growth (today’s median consensus estimate for the current fiscal year EPS compared against the prior fiscal year EPS);
- Next year’s projected EPS growth (today’s median consensus estimate for next year’s EPS compared against the median consensus estimate for the current fiscal year EPS);
- Quarterly earnings momentum for the next quarter (this figure looks at the latest median estimate for the upcoming quarter’s EPS, adds the trailing three quarters of reported EPS, and compares the figure to the trailing four quarters of reported EPS);
- Earnings variability (this is a measure of how consistent a company’s earnings are over the past five years, lower scores preferred);
- Market cap (here, large companies are preferred as a safety factor);
To qualify, stocks must be well ranked based on the above factors, but must also have a positive current year median EPS estimate, positive trailing four quarters of EPS and at least five analysts actively covering the stock.
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 February, 1994, to April, 2017. During this process, a maximum of 15 stocks were purchased with a maximum of four per economic sector to ensure reasonable diversification. Stocks are sold if their rank falls below the top 25 per cent of the universe, or if the company missed EPS expectations in a given quarter by more than 5 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 14.2 per cent while the S&P 500 total return index gained 9.2 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.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.