What are we looking for?
Value-focused stocks outside of the S&P/TSX Composite Index.
Value investing is a well-known and commonly used style of investing. The basic premise is to search for stocks that appear to be undervalued – that is, currently trading below what the buyer believes the stock is truly worth, otherwise known as its intrinsic value.
When choosing a universe of stocks to explore for value in Canada, one of the most obvious choices is the S&P/TSX Composite. But the main domestic stock index isn’t the only source for value hunters. Indeed, lower-profile stocks that have less coverage by equity analysts can hold potential gems. Today, I’m going to look outside of the commonly used index and instead focus on some of those lesser known Canadian names.
Today’s strategy looks to find Canadian value stocks among the CPMS Canadian universe, excluding the S&P/TSX Composite – currently, this universe holds 463 names. In order to qualify, stocks must have a:
- Price-to-forward-earnings ratio (measured as the company’s most recent share price divided by the estimated annual earnings per share; low values best) in the top half of peers – currently, this value is 12.8 times or lower;
- Price-to-book-value (measured as the company’s most recent share price dividend by the book value per share, low values best) in the top half of peers – currently, this value is 1.2 times or lower;
- Return-on-equity (a growth metric) greater than the top 50 per cent of peers; currently, this value is 2.9 per cent or higher;
- Five-year beta relative to the S&P/TSX Composite less than or equal to one (this measures a company’s sensitivity relative to changes in the benchmark – a value less than one would indicate the stock is less volatile than the market);
- Monthly trading volume (a measure of liquidity – the total dollar value of shares traded in the previous calendar month) in the top two-thirds of peers – currently, this value is $2.2-million or higher.
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 December, 1991, to February, 2019. During this process, a maximum of 15 stocks were purchased. Stocks were sold if the company’s price-to-forward-earnings rose (we want a lower value) into the bottom third of peers. 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 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 17.8 per cent while the S&P/TSX Total Return Composite Index returned 8.3 per cent across the same period. 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.