What are we looking for?
A portfolio of U.S. stocks with healthy balance sheets.
The screen
It can be difficult to determine whether a company is a good investment during periods of volatility such as what we experienced in the first quarter of 2020. With a number of analysts revising EPS estimates downward, how can you tell if a stock is worth buying, or whether you should avoid it?
One way to assess a company’s health is by using its balance sheet. Recall that a balance sheet is a financial statement outlining a company’s assets, liabilities and shareholders’ equity. We can use the information in this statement to help assess how a company currently stands and whether or not it is well equipped to withstand unprecedented conditions such as the current pandemic.
Today’s strategy looks for companies with strong balance sheets in the CPMS U.S. universe – today this consists of 2,092 names. This strategy ranks stocks based on: long-term debt-to-equity (lower values preferred); trailing return of equity or ROE (a profitability metric, higher values preferred); five-year beta (a measure of the sensitivity of a stock compared with a market index – here we use the S&P 500 – lower values preferred); and cash flow/debt (higher values preferred).
In order to qualify, stocks must have:
- A debt-to-equity ratio less than or equal to 1.1, to remove highly leveraged companies;
- A debt-to-total-assets ratio (a measure of leverage) in the lower two-thirds of peers – today this equates to a value of 0.4 or lower;
- Cash-flow-to-debt in the top two-thirds of peers – today this equates to a value of 0.27 or higher;
- A market capitalization in the top two-thirds of peers (in order to remove any small cap stocks) – today this equates to a value of US$1.3-billion or higher;
- Trailing ROE in the top third of peers – today this equates to a value of 16.9 per cent or higher;
- Five-year beta of less than 1.3.
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.
What we found
I used Morningstar CPMS to back-test this strategy from April, 2004, to April, 2020. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their debt-to-equity rose above 1.3 or if their cash-flow-to-debt fell into the bottom third of peers. 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 12.9 per cent while the S&P 500 returned 8.5 per cent on the same basis. It’s also worth noting that the model has lost 3.2 per cent year-to-date as of April 30, while the market has declined 9.3 per cent across the same time frame.
Stocks that qualify for purchase into the strategy today are shown in the accompanying table. As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed below.
Emily Halverson-Duncan, CFA, is a director, CPMS sales at Morningstar Research Inc.
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Emily Halverson-Duncan, CFA