What are we looking for?
Companies in the financials and industrial sectors with solid cash flow.
The screen
Today’s focus is on two sectors expected to benefit from higher interest rates, with economic growth as a tailwind for higher investment returns. The industrial sector has a high correlation to interest rates because it tends to do well when the economy is growing. The financial sector, too, generally expands its profit margins, in this case benefiting from the growing interest rate “spread” that accompanies this environment.
The quarterly cash flow variable is a short-term metric that measures the rate of change of quarterly cash flow from operations per share. It is the percentage change between the latest four quarters of reported cash flow from operations per share and the four quarters of cash flow from operations per share from one quarter ago.
Then I used the annual cash flow momentum (latest four quarters of operating cash flow versus the same period a year ago) as a medium-term metric, and the five-year cash flow growth rate as a longer-term metric.
With interest rates expected to rise, we want to make sure companies have enough cash flow to cover the amount of debt outstanding, so I used the cash-flow-to-debt ratio. I placed a $500-million limit on market capitalization to eliminate micro cap stocks and reduce the liquidity risk. Lastly, I used the price-to-cash-flow ratio to identify companies that have lower valuations.
The investment process started off with all 66 stocks in the financial and industrial sectors that have a market cap above $500-million in our CPMS database. Then we ranked our stocks according to quarterly and annual cash flow momentum, five-year cash flow growth rate and debt-to-cash-flow.
Next, we applied the following screens:
- Price-to-cash-flow ratio less than 12;
- Cash-flow-to-debt ratio greater than 0.2;
- Quarterly cash flow momentum greater than zero;
- Annual cash flow momentum greater than zero;
- Five-year cash flow growth rate greater than zero.
Note: Quarterly cash flow momentum, annual cash flow momentum or five-year cash flow rate can be negative – as long as all three metrics are not negative at the same time.
What we found
I used CPMS to back-test the strategy from January, 2006, to December, 2021. During this process, a maximum of 10 stocks were purchased and equally weighted. The portfolio is rebalanced monthly and the strategy produced a total return of 12.3 per cent since inception whereas the S&P/TSX Composite Total Return Index advanced 6.8 per cent over the same period. Today, the stocks that qualify for purchase into the strategy 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.
Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
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Phil Dabo, MFin