What are we looking for?
Canadian momentum stocks that are undervalued relative to peers.
It’s not uncommon to hear a money manager describe themselves as a “value investor.” Value investing refers to the practice of purchasing stocks that are currently considered undervalued relative to their “intrinsic value” – the value the stock is expected to be worth based on analysis.
While this style of investing is very popular, you also bear the risk that one or more of your undervalued stocks may continue to decline in value. Today, I’ve built a strategy that attempts to combat this risk by also taking momentum factors into consideration. The momentum factors serve as a check to ensure stocks appear to be trending upward in addition to being undervalued.
This strategy looks for Canadian names within the CPMS Canadian universe (today, this universe consists of 698 names). Stocks are ranked based on trailing price-to-earnings (lower value is best); quarterly earnings momentum (measured as the growth in the most recent four quarters' earnings relative to the most recent four quarters' earnings lagged by one quarter, higher value is best); and a stock’s price change from 12-month high (a momentum factor, least-negative value is best). In order to qualify, stocks must have:
- Quarterly earnings momentum greater than zero;
- Quarterly earnings surprise greater than zero (proprietary measure of the difference between actual and expected quarterly earnings, higher value is best);
- Annual earnings momentum (measured as the growth of annual earnings per share) greater than zero;
- Trailing price-to-earnings ratio in the lowest two-thirds of peers (today, this value is a P/E less than or equal to 28.8);
- Price-to-book ratio (another value factor) in the lowest two-thirds of peers (today, this value is a P/B less than or equal to 2.8).
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 110 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 June, 2002, to June, 2018. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their quarterly earnings momentum or their quarterly earnings surprise dropped below minus 8 per cent. 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 19.1 per cent while the S&P/TSX Composite Total Return Index gained 8.1 per cent across the same period. One thing worth noting is that the strategy’s downside deviation (measures the volatility of negative returns) was 7.9 per cent relative to the benchmark’s downside deviation of 8.6 per cent. 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 here.
Emily Halverson-Duncan, CFA, is a director, CPMS sales, at Morningstar Research Inc.