What are we looking for?
A diversified portfolio of undervalued companies.
As the S&P/TSX Composite Index continues to reach record-breaking highs, some investors are becoming more interested in finding companies with lower valuations. The appeal of undervalued stocks is that their price will rise as more people come to appreciate the true value of the company’s fundamental business. However, over the past 10 years, stocks of companies that have lower valuation multiples have for the most part underperformed those that are more growth-oriented and carry higher valuation multiples.
Today I use Morningstar CPMS to look for companies of all sizes that have lower valuation ratios. The four fundamental valuation ratios that I used are the price to book, price to cash flow, price to sales and the forward price to earnings (calculated as the latest price per share divided by the median earnings-per-share estimate for a company’s current year). The 90-day earnings-estimate revision was used to identify companies for which analysts have a positive outlook. We also used the Morningstar Quantitative Financial Health Score to identify companies that have strong balance sheets. This is a proprietary metric that measures the probability that a firm will fall into financial distress or default on its financial obligations. We use this score along with return on equity, which is also a good metric of financial performance that incorporates the net profit margin, return on assets and financial leverage.
The investment process started off with all 700 Canadian stocks in our CPMS database. Then we ranked our stocks from 1 to 700 according to the price to book, price to cash flow, forward price to earnings, price to sales and 90-days earnings revision. Each criteria was equally weighted at 20 per cent in determining the ranking.
Next, we applied three screens to create our list of stocks:
- Market capitalization above $500-million
- Trailing return on equity above 15 per cent
- Morningstar Quantitative Financial Health Score above 0.5
What we found
I used CPMS to back-test the strategy from May, 2001, to August, 2021. During this process, a maximum of 15 stocks were purchased and equally weighted. The portfolio is rebalanced monthly and the strategy produced a return of 14.5 per cent since inception, whereas the S&P/TSX Total Return Index returned 7.5 per cent. Today, the top 15 stocks that qualify for purchase under 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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