What are we looking for
Slow and steady stocks in the S&P 500.
The screen
As investors continue to keep a keen eye on the trade war, many are likely somewhat relieved that the Federal Reserve will react appropriately and may consider cutting rates in reaction to the escalating trade war. Either way, investors who are bracing for an equity correction may consider this week’s idea that looks for S&P 500 companies showing a good combination of the following medium/long-term historical fundamental measures.
- Five year historical beta, which is a measure showing historically how sensitive the stock price is to the S&P 500. In trending markets, stocks that have low betas have moved less than the index. Here, we prefer lower figures;
- 10 year average return on equity (ROE);
- 10 year earnings-per-share growth rate;
- 10 year deviation of ROE and EPS (a statistical measure of how volatile a company’s ROE or earnings have been, lower figures preferred);
To qualify, stocks must pay a dividend yield of 2.4 per cent or higher (a figure representing the median yield in the S&P 500 today). Additionally, stocks must pay out less than 80 per cent on expected earnings or 60 per cent on operating cash flows to be considered to ensure dividends are reasonably sustainable.
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 February, 2006, to April, 2019. During this process, a maximum of 15 stocks were purchased and equally weighted with no more than four in each economic sector. Once a month, stocks were sold if their rank fell below the top 30 per cent of the S&P 500 based on the above factors. 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 return of 9.8 per cent while the S&P 500 returned 8.8 per cent. There were 50 months, 14 quarters and two calendar years over this time period when the S&P 500 showed a negative return. Of these months/quarters/years, our model outperformed the market 82 per cent, 85 per cent and 100 per cent of the time, respectively, outlining the defensive nature of this strategy.
The stocks that qualify for purchase today and are listed in the table below. It is always recommended to speak to a financial adviser or investment professional before investing.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.
Ian Tam, CFA