What are we looking for?
Small and mid-cap companies with a competitive advantage and low valuations.
Companies with a wide economic moat have a sustainable competitive advantage that helps protect their market share and profitability. Typically, these companies have a product or brand that is hard to replicate, which creates an effective barrier against competition. Applying Morningstar’s Quantitative Economic Moat score to companies that have smaller market capitalizations can help us identify ones that can efficiently scale their resources and become larger companies in the future.
Today, I use Morningstar CPMS to look for small and mid-cap U.S.-listed companies that have some form of economic moat. Once we have a short list of companies that have a narrow or wide economic moat, we’re going to eliminate the ones that have two specific valuation metrics that are higher than the S&P 500. The price-to-book ratio will help us find companies that have a higher net book value in relation to the price per share. Price-to-sales will help us find companies that have strong revenue figures in relation to the per-share price.
Both valuation metrics are important when looking at companies that have an economic moat because we want to find strong profitability and high net asset values, but we also want to buy the stock when it’s relatively cheap. Our last factor is a price momentum variable that has good downside protection – the price change from the stock’s 12-month high. We’ve found that stocks trading close to their 12-month high tend to perform well.
The investment process started off with all 2,000 U.S. stocks in our CPMS database. Then we ranked our stocks according to the Quantitative Economic Moat, price-to-book and price-to-sales ratios.
Next, we applied five screens to create our list of stocks:
- Market capitalization below US$10-billion;
- Morningstar Quantitative Economic Moat Score of three or higher (out of five);
- Price-to-book below 4.7 (the average of the S&P 500);
- Price-to-sales below 3.5 (the average of the S&P 500);
- Price change of 7 per cent or less from the stock’s 12-month high.
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.
What we found
I used CPMS to back-test the strategy from January, 2006, to May, 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 13.3 per cent since inception, whereas the S&P 500 Total Return Index advanced 10.3 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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