What are we looking for?
U.S. companies that have a history of growing their cash flows.
Experienced long-term investors know that the outcome of U.S. elections doesn’t always tie directly to the performance of the economy or, indeed, that of the stock market over the medium to long term. For example, the real GDP growth rate in the United States during the final three years of former president Barack Obama’s administration was about 2.4-per-cent annualized, while the same figure during the first three years of President Donald Trump’s term was 2.3-per-cent annualized – not a large differential despite radically different ideologies.
The performance of the U.S. stock market during the pandemic this year further bolsters the idea that the economy itself is often disconnected with stock prices – exemplified by the S&P 500 remaining strong while economic conditions in the U.S. are weaker because of the pandemic.
All this said, this week’s strategy looks for U.S.-listed companies that have a history of growing and stable operating cash flow. As a metric, cash flow speaks to a company’s agility in being able to cover unexpected expenses, finance expansion, pay debt obligations and issue dividends. The idea here is that these companies might be able to weather poor economic conditions (more to do with the pandemic than the outcome of the election) better than others. To find them, I used Morningstar CPMS to screen the 2,100 U.S. companies in our database on the following metrics:
- Annual cash flow momentum (latest four quarters of operating cash flow compared with the same metric from the previous four quarters, higher figures preferred);
- Five-year cash flow growth rate (on average, how much operating cash flow has grown each year in the past five);
- Return on invested capital (calculated as the after-tax net operating profit divided by outstanding debt and equity, higher figures preferred);
- Price-to-trailing-cash flow (a value metric to ensure we are not overpaying for cash flow);
- Five-year deviation of earnings (which measure the consistency of reported earnings over the past five years, lower figures preferred);
To qualify, companies must have a market cap greater than the bottom one-third of companies in our universe (today that figure is US$980-million). To avoid overly leveraged companies, a screen was placed removing companies with a cash-flow-to-debt ratio of less than the median of the universe, which today is 0.25 (not shown).
Finally, a screen was placed to look for companies that have a ESG Risk rating better (lower) than two-thirds of the market. The Sustainalytics ESG Risk rating measures the company’s exposure to and management of material environmental, social and governance issues. This rating measures a company’s exposure to industry-specific material risks, as well as how well a company is managing those risks.
More about Morningstar
Morningstar Research Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. Morningstar offers an extensive line of products and services for individual investors, financial advisers, asset managers, retirement plan providers and sponsors, and institutional investors. Morningstar Direct is the firm’s multi-asset analysis platform built for asset management and financial services professionals. Morningstar Canada on Twitter: @MorningstarCDN.
What we found
I used Morningstar CPMS to back-test this strategy from January, 2006, to September, 2020, using a maximum of 20 stocks with no more than four for each 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. The ESG risk ratings were implemented in the model in November of 2019, at which point stocks were sold if they did not meet the ESG requirement. When stocks were sold, they were replaced with the highest ranking stock not already held in the portfolio. Over this period, the strategy returned 14.9-per-cent annualized, while the S&P 500 Total Return Index produced 9.1 per cent on the same basis. The top 20 stocks that qualify for purchase into the strategy today are listed in the accompanying table.
This article does not constitute financial advice. It is always recommended to speak to a financial adviser or professional before investing in any of the companies listed here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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