What are we looking for?
Relative value with stability in the S&P/TSX Composite Index.
The fact that a value strategy (investing in companies trading below fair value) has underperformed growth (investing in companies that are increasing their earnings quickly) over the past few years is a phenomenon that is likely top of mind for many investors. For those that believe this trend is set to turn, perhaps owing to the stock market’s tendency to revert to the mean, this week’s strategy may offer some reasonable ideas. The model looks for companies with a long track record of stability but are trading below their sector-median valuation multiples. To find these companies, I first used Morningstar CPMS to rank stocks in the S&P/TSX Composite on the following long-term stability factors:
- 10-year deviation in earnings per share (a statistical metric measuring how consistent a company’s earnings have been over the past 10 years, lower values preferred);
- 10-year average return on equity.
To qualify, companies must have price-to-earnings, price-to-cash-flow, price-to-book and price-to-sales ratios that are equal to or less than that of the stock’s own sector median. In the accompanying table, a value of 0.9 would imply that the company’s valuation metric is 10 per cent lower than that of a sector.
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 December, 1995, to the end of October, 2019. During this process, a maximum of 15 stocks were purchased and equally weighted. Once a month, stocks were sold if their rank fell below the top 35 per cent of the universe, or if any of the aforementioned relative value metrics exceeded the sector median by 50 per cent or more. Over this period, the strategy produced an annualized total return of 12.8 per cent while the S&P/TSX Composite Index gained 7.9 per cent on a total return basis. On a trailing 12-month basis ended Oct. 31, 2019, the strategy underperformed, gaining 12.9 per cent while the index registered a total return of 13.3 per cent.
Today, only 14 stocks qualify for purchase. They 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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