What are we looking for?
Sector leaders exhibiting value and growth.
After a large correction like the one we saw in March, 2020, it can often be observed that deep value stocks are among the first to bounce back in the Canadian market. With a full year now behind us after the pandemic sell-off, investors may be wondering whether there are still value picks to be had. One way to do this is to compare stock valuation metrics with the median valuations of their sector. To this end, today I use Morningstar CPMS to create a strategy that ranks the 720 companies in our Canadian database on the following metrics:
- Sector-relative price-to-earnings, price-to-book, price-to-sales and price-to-cash-flow ratios. (Here we compare the multiple of the stock against the median of the sector to which it belongs. For example, a sector-relative P/E ratio of 0.8 would imply that the company’s P/E ratio is 20 per cent lower than that of the sector. Lower figures preferred.)
- Sector-relative return on equity and the five-year growth rate of earnings per share. (For these two measures, we take a difference between the company and the sector. For example, a sector-relative five-year EPS growth rate of 5 per cent would imply that over the past five years the company’s earnings have grown, on average, by 5 per cent more than the sector. Higher figures preferred.)
The idea here is to look for companies that appear undervalued relative to the sector, yet are growing faster and are more profitable. Only companies with a market float greater than $110-million were included (this figure represents the bottom one-third of the database by size). As a reminder, market float refers to the total value of shares available to investors and not owned by majority shareholders.
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: @MorningstarCDN.
What we found
I used Morningstar CPMS to back-test this strategy from June, 1990, to March, 2021, using a maximum of 15 stocks with no more than four per economic sector. Once a month, stocks were sold if they fell below the top 35 per cent of the index based on the aforementioned metrics and replaced with the highest ranking stock not already held in the portfolio. On this basis, the strategy produced an annualized total return of 12.2 per cent, while the S&P/TSX Composite Total Return Index advanced 8.3 per cent.
The stocks that meet the requirements to be purchased today are listed in the accompanying table. This article does not constitute financial advice. It is always recommended to speak with a financial adviser or professional before investing.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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