What are we looking for?
Companies that appear undervalued, with a positive earnings outlook.
With growth-oriented stocks such as Netflix Inc. down about 30 per cent since the beginning of the year, some investors are looking for value-oriented companies with strong fundamentals that they believe will perform well during a rising interest-rate environment. Investors who use this strategy hope the stock price will rise as more people come to appreciate the true value of the company’s fundamental business.
Today I use Morningstar CPMS to look for companies that have lower valuation ratios than the S&P 500 average. I used four common valuation ratios:
- Price-to-book ratio is the market value per share (price per share) of a company divided by the book value per share (the net difference between a company’s total assets and total liabilities divided by shares outstanding), and indicates how much an investor is willing to pay for the book value of that company.
- Similarly, the price-to-cash-flow is an indication of how much one is willing to pay for the operating cash flow of the business.
- Forward price-to-earnings indicates how much one would pay for the company’s forecast earnings.
- Price-to-sales ratio indicates how much one is willing to pay for the sales of the business.
When all of these value factors are taken into consideration, we are looking for companies that are trading at a discount compared with the average company on the S&P 500. (The S&P 500 average price-to-book is 2.7; average price-to-cash-flow is 12.7; average forward P/E, 16.6; and the average price-to-sales is 2.3.)
We are also looking for companies to which Street analysts have assigned a positive outlook. We have limited our search to companies where the median analyst earnings estimate for the past three months of the current fiscal year has been revised upward.
Lastly, I 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.
The investment process started off with all 2,100 U.S. stocks in our CPMS database. Then we ranked our stocks according to the price-to-book, price-to-cash-flow, price-to-sales, and forward price-to-earnings ratios, and the three-month estimate revision.
Next, we applied two screens to create our list of stocks:
- Market capitalization above US$1.5-billion;
- Morningstar Quantitative Financial Health Score higher than 0.5, which is better than 60 per cent of the companies in the CPMS database.
What we found
I used CPMS to back-test the strategy from January, 2006, to December, 2021. During this process, a maximum of 15 stocks were purchased and equally weighted. The portfolio is rebalanced monthly and the strategy produced a total return of 13.9 per cent since inception whereas the S&P 500 Total Return Index returned 10.8 per cent. Today, the top 15 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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