What are we looking for?
A portfolio of Canadian companies with solid balance sheet metrics.
Determining which companies to buy can be a difficult process, especially when you consider the vast amount of research and resources available to use. Some investors focus more on trends, such as price momentum, whereas others look for companies with the best yields. One tool that is readily available to use is a company’s balance sheet. Recall, a balance sheet details a firm’s assets, liabilities and shareholders’ equity. The balance sheet can be used to determine a company’s financial health, as measured by different financial ratios – several of which we will look at today.
Today’s strategy looks for stocks with good balance sheet ratios. This strategy ranks stocks based on:
- Long-term-debt-to-equity ratio (a leverage control, lower values preferred);
- Buyback yield (a measure of company shares that have been repurchased as a percentage of market capitalization, higher values preferred). A higher buyback yield is considered a positive for shareholders as it typically indicates an affirmative signal from company management and often results in an increase in share price;
- Five-year price beta (a measure of price sensitivity relative to the benchmark, in this case the S&P/TSX Composite Index, lower values preferred).
In order to qualify, stocks must have:
- Working capital (calculated as current assets minus current liabilities, high values preferred) greater than or equal to zero;
- Debt-to-equity ratio less than or equal to one, to remove highly leveraged companies;
- Debt-to-cash-flow ratio less than or equal to three;
- Buyback yield in the top half of peers – today this value is equal to 0.75 per cent or higher;
- Five-year price beta less than or equal to one;
- Market cap in the top two-thirds of peers in order to remove any microcap stocks – today this equates to a value of $115.5-million or higher.
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 110 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 January, 2000, to October, 2020. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their debt-to-equity rose above 1.5 or if their debt-to-cash-flow rose above three. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 13.4 per cent while the S&P/TSX Composite Total Return Index returned 5.7 per cent on the same basis.
Stocks that qualify for purchase into the strategy today 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.
Emily Halverson-Duncan, CFA, is a director, CPMS sales at Morningstar Research Inc.
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