What are we looking for?
U.S. stocks displaying strong value ratios relative to their history.
Given the near record valuation highs of the S&P 500, investors should be wary of increasing their position in U.S. stocks. Nonetheless, even with many stocks overvalued, there are some that display discounted prices when considering their past values.
With that said, today I use Morningstar CPMS to look for profitable companies that display strong value characteristics compared to their own history.
The specific factors used to rank stocks in this strategy include:
-Forward P/E ratio relative to the 10-year historical median (the difference between the stock's current forward P/E ratio versus the median value of this ratio over the past 10 years – for example, a figure of 0.9 means that the current forward P/E ratio is 10 per cent lower than the historical median);
-P/B ratio relative to the 10-year historical median (the difference between the stock's current price-to-book versus the median value of this ratio over the past 10 years);
-Forward return on equity (a profitability metric that divides the current consensus EPS by the adjusted book value of equity).
To qualify, stocks must be trading at a discount relative to the historical median over the past 10 years when looking at both forward P/E and P/B. Stocks must also have a market cap of $250-million or greater.
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 CPMS to back-test the strategy from December, 1993, to May, 2016. During this process, a maximum of 15 stocks were purchased and equally weighted. Stocks would be sold if they fell outside the top 50 per cent of the ranked universe or if the stock's market cap fell below $200-million. Stocks would also be sold if the historical-relative price-to-earnings or historical-relative price-to-book values become greater than 1.2, indicating they are overvalued. The strategy is rebalanced on a monthly basis.
Over this period, the strategy produced an annualized total return of 16.5 per cent, while the S&P 500 total return index advanced 9 per cent. Today, 15 stocks qualify for purchase into the strategy and 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.
Michael Pe, CFA, is an institutional product specialist for CPMS at Morningstar Research Inc.