What are we looking for?
Canadian companies showing stability and steadiness.
Tuesday’s negative price action on Canadian stocks may have given jittery investors some pause, and rightly so. At present the median price-to-book ratio of Canadian stocks sits at 1.9, a figure that is very close to what was observed just prior to the financial crisis (1.8 in June, 2008). Investors who are looking to take the foot off the gas pedal may benefit from today’s strategy, which focuses on companies with a history of stability. To find these companies, I ranked the 710 companies in the Morningstar CPMS Canadian database on four stability factors:
- Five-year deviation in each of: earnings, return on equity and total return. Recall that deviation is a statistical measure that captures consistency. Today we measure this over five years of history and across a company’s earnings per share, profitability (net earnings of a company against shareholder equity) and price action. Lower figures preferred.
- Five-year historical price beta. Recall that beta measures the historical sensitivity of a stock against an index (in our case the S&P/TSX Composite Index). Stocks with a beta less than one have historically moved less than the index in trending markets. Lower betas preferred.
To qualify, stocks must have positive five-year earnings growth rate and positive return on equity. Additionally, only stocks with a market float greater than the median of the universe, which today sits at $400-million, were considered. Market float refers to value of shares outstanding not held by majority shareholders (that is, what’s available to retail investors).
What we found
I used Morningstar CPMS to back-test this strategy from January, 2004, to the end of January, 2021, using a portfolio of 15 stocks and never holding more than four stocks per economic sector. Once a month, stocks that fell beyond the top 25 per cent of the universe based on the above factors were sold and replaced with the next highest-ranking stock not already owned in the portfolio, respecting the aforementioned sector limits. Over this period, the strategy produced 9 per cent annualized while the S&P/TSX Composite Total Return Index advanced 7.2 per cent.
Though these results aren’t terribly impressive, it is the defensive characteristics of the strategy that shine through. Of the 204 months tested, there were 75 months where the index showed negative returns. Of these losing months, our strategy outperformed the index 76 per cent of the time (57 of 75 months).
Moreover, in the financial crisis of 2008 the strategy lost 17.6 per cent while the index lost 33 per cent. Over all, the Sharpe ratio (a measure of return per unit of risk) clocked in at 0.8 compared with 0.3 for the index. The portfolio’s higher figure alludes to a more risk-efficient strategy than simply buying the index.
The stocks that qualify today to be purchased into the strategy are listed in the accompanying table. This article does not constitute financial advice. It is always recommended to speak with a financial adviser or investment professional before purchasing any of the securities shown here.
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.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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