What are we looking for?
Canadian-listed companies growing their cash flow.
For investors, the idea of a “rising interest rate environment” is now on the back burner after the U.S. Federal Reserve cut rates in its July 31 announcement, with the U.S. trade war with China looming in the background. On the home front, the Bank of Canada kept rates steady in its announcement earlier in July, also pointing to tensions between the world’s two largest economies.
If lower interest rates mean rising corporate debt costs are less of an issue now, is cash flow still king? The short answer is yes. A company’s cash flow affords it the financial flexibility to re-invest in projects, weather downturns and pay dividends to shareholders. So even if higher debt costs are no longer a top-of-mind concern, cash flow is still very important. This week, I use Morningstar CPMS to rank the 702 Canadian companies in the database on the following factors to build a model that seeks companies with growing cash flow:
- Five-year operating cash flow growth rate (on average how much cash flow is growing each year in the past five years);
- Free cash flow yield (compares free cash flow against a company’s enterprise value, higher values preferred);
- Quarterly and annual cash flow momentum (trailing four quarters’ operating cash flow compared with the same figure one quarter and four quarters ago, respectively);
- Standard deviation of total returns over the past 180 days (measuring the volatility of the company’s stock price over the past six months, lower figures preferred).
Only companies with a market float (defined as the value of outstanding shares not held by insiders) of greater than $840-million were considered in this analysis. This figure is meant to exclude the bottom two-thirds of companies in the universe by size. Additionally, to qualify the companies must pay a dividend.
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 August, 2004, to July, 2019. During this process, a maximum of 15 stocks were purchased and equally weighted with no more than three for each economic sector. Once a month, stocks were sold if their rank fell below the top 35 per cent of the universe, or if the company stopped paying dividends. 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 total return of 15.5 per cent while the S&P/TSX Composite Total Return Index advanced 7.6 per cent. In the trailing 12-month period ended July, 2019, the strategy gained 18.4 per cent while the index rose 3.1 per cent.
The stocks that qualify for purchase today 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.
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