What are we looking for?
Growth at a reasonable price.
Despite the stellar performance of Canadian equities this calendar year, valuations on Canadian stocks still seem to be in reasonable shape. During the late 2018 market correction, the price-to-earnings ratio of the S&P/TSX Composite dipped to lows of 13.8 and now sits at 16.2. Both figures pale in comparison with January, 2017, when it rose up to 21.
Regardless, no investor likes to overpay for earnings. So this week I revisit the concept of GARP (growth at a reasonable price) investing by creating a model that ranks stocks in the S&P/TSX Composite Index on:
- Forward price-earnings-to-growth, or PEG ratio (calculated by dividing the forward P/E ratio by the estimated growth rate of earnings as predicted by Street analysts, low values are better);
- Five-year earnings per share deviation (a stability measure outlining how stable a company’s earnings have been over the past five years, low values are better);
- Estimated annual growth rate of earnings (current year median estimate of earnings compared against the estimate for the prior fiscal year);
To qualify, companies must have a positive trailing return on equity and must pay a dividend. Screens for payout ratio on trailing cash flow and earnings of less than 60 per cent and 80 per cent, respectively, were also applied to ensure dividends are reasonably sustainable.
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 120 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to back test this strategy from May, 1992, to the end of November, 2019. During this process, a maximum of 15 stocks were purchased and equally weighted with no more than four stocks for each sector. Once a month, stocks were sold if their rank fell below the top 35 per cent of the universe, or if the company’s dividend payout ratios on cash flow or earnings exceeded 80 per cent or 100 per cent, respectively. Over this period, the strategy produced an annualized total return of 11.7 per cent while the S&P/TSX Composite Index gained 8.7 per cent on a total return basis. In the trailing 12-month period ended Nov. 30, the strategy produced a total return of 20.1 per cent while the index gained 15.7 per cent.
Today, only 12 stocks qualify for purchase. They are listed in the table below. It is always recommended to speak to a financial adviser or investment professional before investing.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.
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