What are we looking for?
Stocks with an opportunity for growth that may be overlooked by investors focused solely on valuations.
The price-to-earnings ratio of the S&P/TSX Composite Index has been trending higher over the past 12 months, and as such can give the impression that stocks may be getting too expensive. But if that is the case, does that mean there’s not much opportunity left in the Canadian market?
Today, I’m going to explore this question by showcasing a strategy that looks only at stocks in the extremes of the market – either extremely high or extremely low valuations – both of which are typically assumed to be unattractive. This strategy aims to create a portfolio of stocks that performs well without an excessive amount of risk despite being considered unappealing from a typical valuation standpoint. We rank the stocks according to the following criteria:
- Annual cash flow momentum (current cash flow a share compared with the same metric one year ago);
- Quarterly earnings surprise (proprietary measure of the difference between expected and actual quarterly earnings);
- Percentage change in price from 12-month high (a momentum factor, least negative value is best).
In order to qualify, stocks must have a trailing P/E ratio that is either in the top one-sixth or bottom one-sixth of all stocks (those values today are 29.5 and 10.4, respectively). Stocks must also have positive values for both annual cash flow momentum and quarterly earnings surprise. Cash-flow-to-debt must be in the top one-third of peers to avoid companies that are unable to pay their debts (today this value is 0.4 or higher). Lastly, five-year beta (measure of a company’s sensitivity relative to the benchmark – here we use the S&P/TSX) must be less than 1.
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 December, 2019. During this process, a maximum of 15 stocks were purchased. Stocks were sold if the company’s annual cash flow momentum or quarterly earnings surprise dropped below negative 2 per cent. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio.
As a buffer to account for the less liquid nature of some of these names, a 1-per-cent liquidity cost was applied to each transaction (sold positions received 1 per cent less and bought positions cost 1 per cent more in each historical transaction).
Over this period, the strategy produced an annualized total return of 21.2 per cent, while the S&P/TSX returned 6.2 per cent across the same period. Downside deviation (measured as the variability of negative returns) was 6.8 per cent compared with a downside deviation of 9.5 per cent for the S&P/TSX.
Stocks that qualify for purchase into the strategy today are listed in the table below. 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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