What are we looking for?
A portfolio of U.S. stocks with solid balance sheets.
There are many different metrics investors can use to evaluate the financial health of a company they are considering adding to their portfolio, many of which are derived from the company’s balance sheet. Recall, a balance sheet details a firm’s assets, liabilities and shareholders' equity. Investors can use the balance sheet, among other tools, to determine whether a company they are considering investing in would be a viable option.
Today’s strategy looks for stocks with good financial health based on their respective balance sheets. This strategy ranks stocks according to the following criteria:
- Return on invested capital (ROIC) – a profitability metric, high values preferred;
- Working capital ratio – a measure of liquidity, calculated as the ratio of current assets to current liabilities, high values preferred;
- Cash flow-to-debt ratio, which indicates the company’s ability to carry and service its total debt with its cash flow from operations, high values preferred.
In order to qualify, stocks must have:
- A ROIC greater or equal to 10 per cent;
- A debt-to-equity ratio less than or equal to 0.9, to remove highly leverage companies;
- Working capital ratio in the top half of peers – today this equates to a value of 1.81 or greater;
- Debt-to-total assets ratio (a measure of leverage) in the lower two-thirds of peers – today this equates to a value of 0.36 or lower;
- Cash-flow-to-debt in the top two thirds of peers – today this equates to a value of 0.18 or higher;
- Market capitalization in the top two-thirds of peers in order to remove any micro-cap stocks – today this equates to a value of US$1.93-billion or higher.
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 April, 2004, to June, 2018. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their debt-to-equity rose above 1.1, if their ROIC fell into negative territory, or if the debt-to-total-assets ratio rose into the highest third of values relative to 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 15 per cent while the S&P 500 Total Return Index advanced 8.8 per cent over the same period. 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.