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number cruncher

Craig McGee is a senior consultant at Morningstar Canada.

What we are looking for

High-quality, profitable, Canadian companies that are also undervalued and flying under the radar.

Through our research, we know the market has provided a premium for earnings- and price-momentum characteristics. This week, I will search for companies that have strong gross margins that also have reasonable valuations and strong relative momentum. We'll focus on gross margin (sales less cost of goods), since it's less susceptible to accounting manipulation, and measure it relative to total assets to see how efficiently their assets are being used.

The screen

I used Morningstar CPMS to find the 20 Canadian stocks with the best combination of the following metrics:

-return on equity over the latest four quarters;

-price to earnings over the latest four quarters;

-gross profit to total assets;

-quarterly earnings momentum (that is, the percentage change in the latest four quarters' earnings per share compared with the four quarters' EPS of one quarter ago);

-latest CPMS earnings surprise;

-revision of the current year's consensus earnings estimate over the past three months;

-and return over the past year.

Stocks were screened out if they were in the bottom quarter of the database based on market cap or average volume. Stocks with a negative price change over the past month were also avoided, and 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 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

Using CPMS, we back-tested the strategy to apply the same rules-based approach beginning Nov. 30, 2001. A portfolio of up to 20 stocks was equally weighted, and stocks would be held until they fell outside of the top 40 per cent, at which point they would be replaced with the next top-ranking stock available. Holdings would also be sold if their price dropped by more than 15 per cent in one month.

Over the full time period, the strategy generated an annualized total return of 25.9 per cent compared with 8.3 per cent for the S&P/TSX Composite Total Return Index. In the 12 months ended April 30, 2014, the strategy posted a return of 34 per cent, while the benchmark came in with 21.3 per cent.

Stocks with reasonable valuations and strong relative momentum