What are we looking for?
Larger companies with earnings and sales momentum.
As we continue to see volatility in financial markets, along with the prospect of several interest-rate hikes this year, it is especially important to focus on profitable companies. First, the company must be able to generate strong top-line growth and then it needs to control costs in order to translate revenue into higher bottom-line growth. There are also different accounting methods that may cause net income to be over- or understated. Some of these items include restructuring charges as well as foreign currency gains and losses. Many financial analysts will adjust earnings when they are updating their financial models, however, Morningstar CPMS uses a proprietary methodology to remove non-essential items from the income statement in order to get a clearer picture of actual earnings.
Today I use Morningstar CPMS to look for Canadian companies of all sizes that have really good revenue and have been able to translate that into superior earnings growth. CPMS will adjust earnings per share in order to remove non-recurring items that can lead to misguided conclusions. (For example, CPMS adjusted the earnings of Colliers International Group Inc. upward by approximately 140 per cent, adding more than $1 to earnings per share, after removing items such as amortization of intangible assets and restructuring charges.)
I screened for return on equity because it is an important factor to assess the financial performance of a company that includes profitability, return on assets and leverage.
I included two factors to reduce risk: I used the 180-day standard deviation to reduce price risk, and the historical variability of EPS to find companies with less volatility than others in the CPMS database in reported quarterly earnings.
Lastly, I included two factors to take advantage of price momentum. Stocks trading near their 12-month high have tended to continue to perform well; and I used the three-month relative strength of the stock price to find companies that are outperforming the market. (A company that has a three-month relative strength of 60, for example, has performed better than 60 per cent of the other companies in our database over the past three months.)
The investment process started off with all 700 Canadian stocks in our CPMS database. Then we ranked our stocks according to the market capitalization, annual sales momentum, annual earnings momentum, and three-month relative price strength.
Next, we applied five screens to create our list of stocks:
- Market capitalization above $500-million;
- Forward return on equity above 15 per cent;
- Price decline of less than 20 per cent from the stock’s 12-month high;
- Earnings variability less than 20;
- 180-day standard deviation below 35.
What we found
I used CPMS to back-test the strategy from January, 2006, to January, 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 14.4 per cent since inception whereas the S&P/TSX Total Return Index returned 6.6 per cent over the same period. Today, the top 10 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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