What are we looking for?
Canadian-listed companies that are stable and growing.
Beta is a frequently used statistic for measuring how much market risk is in a portfolio. It can also be used to measure the volatility of a stock compared with the financial market as a whole. Stocks with a beta greater than one have historically moved more than their comparable index in trending markets. While a stock that deviates very little from the market doesn’t add a lot of risk to a portfolio, it can also reduce the potential for greater returns than the market. However, adding stocks to a portfolio that have a lower beta (and therefore lower volatility) can add meaningful diversification benefits if your portfolio beta is greater than one. In addition to beta, we can look for companies that have higher reinvestment rates to capture stocks that are growing organically by investing in profitable opportunities.
Today, I use Morningstar CPMS to look for stocks that are less volatile and that are able to grow organically. To identify companies that are less volatile, I used the five-year beta of a stock compared with the S&P/TSX Composite Index. To identify companies with attractive growth I used the forecast version of the reinvestment rate. It is calculated as an estimate of earnings per share minus the expected dividends per share over in the next 12 months as a percentage of the company’s adjusted book value per share.
The reinvestment rate measures a company’s profitability and its ability to reinvest earnings back into its business and is a common measure of a company’s growth. Furthermore, we want to see companies that have a higher quarterly earnings momentum compared with peers, which is calculated as the percentage change between the latest four quarters of reported operating earnings per share and the four quarters of operating earnings from one quarter ago.
First, we ranked our universe of 700 TSX-listed stocks according to four key factors: five-year beta, forward reinvestment rate, quarterly earnings momentum and the percentage price change from the stock’s 12-month high.
Next, we applied five screens to create our list of stocks:
- Market capitalization of more than $900-million;
- Five-year beta of less than one;
- Annual earnings momentum greater than zero;
- Long-term debt-to-equity less than 2.2;
- Price decline from the previous 12-month high of less than 34 per cent.
What we found
I used CPMS to back-test the strategy from January, 1999, to January, 2021. During this process, a maximum of 15 stocks in the TSX were purchased and equally weighted. Stocks would be sold if their overall rank dropped out of the top half of our universe of stocks or if annual earnings momentum fell below zero. The portfolio is rebalanced monthly and the strategy produced a respectable annualized total return of 14.7 per cent since inception, whereas the S&P/TSX Composite Index returned 7.1 per cent on the same basis. The stocks that currently 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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