What are we looking for?
Canadian companies that prioritize cash flow.
During periods of market turmoil, such as what we’ve been experiencing in 2020, investors are looking for companies that can withstand volatility without taking too big of a hit. One of the most important characteristics to consider is cash flow. Companies that have excess cash on hand will naturally be in a better position to continue making payments on any outstanding debt, maintain dividends paid out to shareholders, or even use that cash to expand the business through new projects and acquisitions.
Today’s strategy searches for Canadian stocks that have excess cash available as well as a good history of increasing their operating cash flow. The strategy’s universe is the CPMS database of Canadian stocks, which today holds 693 names. The strategy ranks stocks based on:
- Annual cash-flow momentum (measures the rate of change of annual cash flow per share, higher values are preferred);
- Five-year cash-flow growth (annualized number, higher values preferred. Note: While the terms are similar, “momentum” typically refers to short-term changes, while “growth” tends to apply to the longer term);
- Latest four quarters of operating cash flow per share (the amount of cash a company generates from business activities, higher values preferred);
- Latest four quarters’ free cash flow per share (operating cash flow less capital expenditures, higher values preferred).
In order to qualify for purchase, stocks were required to have annual cash flow momentum, five-year cash-flow growth, and their latest four quarters of both operating and free cash flow to have positive values. They were also required to have a five-year beta of one or less. (Recall that beta is a measure of a company’s sensitivity relative to changes in the benchmark – here we use the S&P/TSX Composite Index.)
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 September, 2004, to March, 2020. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their annual cash-flow momentum, five-year cash-flow growth, or latest four quarters of operating or free cash flow were below zero. 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 15.3 per cent while the S&P/TSX Composite Index returned 5.8 per cent on the same basis. One thing worth noting is that year-to-date, the strategy has posted returns of minus 16.5 per cent whereas the S&P/TSX Composite has declined 20.9 per cent, indicating that companies with better cash flow on hand were better able to withstand volatility.
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 below.
Emily Halverson-Duncan, CFA, is a director, CPMS sales at Morningstar Research Inc.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.