What are we looking for?
Outperforming Canadian stocks that have low levels of ESG risk.
Given the rocky Canadian equity markets of late, younger investors, who are often enthusiastic consumers of newsfeeds and social media, are reminded that what may appear to be the end of the world today will likely seem like a small bump in the road when looking back over their long investment time horizon. Along these lines, young investors might also consider environmental, social and governance (ESG) risk factors when investing, because these risks may take many years to materialize. It is for this very reason that the Canadian Pension Plan Investment Board employs a strong sustainable investment mandate, given it is managing wealth for multiple generations of Canadians (a very long time horizon). To this end, today I use Morningstar CPMS to look for Canadian companies that have outperformed the S&P/TSX Composite Index over the past 12 months and exhibit low degrees of ESG risk. To create this strategy, I first ranked the 709 companies in our Canadian database on the following factors:
- Five-year average return on equity (calculated by dividing net income by shareholder equity);
- Trailing return on equity;
- Five-year EPS growth rate (on average how much earnings have grown each year over the last five);
- Morningstar Sustainalytics’ ESG Risk rating.
To qualify, stocks must have an ESG risk score less than 20. For reference, Morningstar Sustainalytics methodology associates scores with the degree of unmanaged ESG risk inherent in a company. Those with a score from zero to 10 have negligible ESG risk, from 10 to 20 have low risk, 20 to 30 medium risk and those scoring between 30 and 40 have high ESG risk. Scores exceeding 40 pinpoint companies with severe degrees of ESG risk. Additionally, given the rise in interest rates, a screen was placed to ensure the debt-to-equity ratio of qualifying companies is less than or equal to that of the sector to which it belongs (in the table, a figure of 0.9 implies that the company is 10 per cent less leveraged than peers). Finally, only stocks that have outperformed the S&P/TSX Composite Total Return Index over the past 12 months were considered, noting that the index fell by 4.5 per cent over that period.
What we found
I used Morningstar CPMS to back-test the strategy from November, 2018, to May, 2022, assuming an equally weighted 15-stock portfolio with no more than four stocks per economic sector. Once a month, stocks were sold if they fell below the top 35 per cent of the universe based on the above metrics. When sold, stocks were replaced with next qualifying stock not already held in the portfolio. The strategy produced an annualized total return of 13.7 per cent, while the S&P/TSX Composite Total Return Index advanced 12.6 per cent on the same basis. Only 12 stocks qualify to be purchased into the strategy today and they are listed in the accompanying table.
This article does not constitute financial advice. Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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