What are we looking for?
Canadian companies showing earnings growth that do not appear overleveraged.
As the Bank of Canada continues to raise rates, equity investors must be cognizant of the rising cost of debt for companies in their portfolios. With this in mind, I use Morningstar CPMS to look for companies in Canada that have shown fundamental growth, but without being overleveraged – thereby reducing the effect that the cost of debt will have on the company’s financials. To find these companies, I rank the Morningstar CPMS Canadian universe (today consisting of 700 companies) by the following metrics:
- Long-term debt-to-equity ratio (a leverage metric, lower figures preferred);
- Dividend yield;
- Five-year revenue and earnings-per-share growth rates (on average, how much the top and bottom lines have grown over the past five years);
- Five-year deviation of EPS (a statistical measure showing how volatile a company’s earnings have been over the past five years, lower figures preferred here).
To qualify, companies must have a market capitalization of at least $180-million (this figure roughly represents the median stock in our universe), and must have a debt-to-equity ratio less than that of the sector to which it belongs; that is, less than one. Companies must also have a dividend payout ratio less than 80 per cent to ensure dividends are sustainable.
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 May, 1992, to October, 2018. During this process, a maximum of 20 stocks were purchased and equally weighted with a maximum of five stocks for each economic sector. Once a month, stocks were sold if their rank fell below the top 35 per cent of the ranked universe. 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 13.4 per cent while the S&P/TSX Composite Total Return Index advanced 8.4 per cent. The stocks that meet my requirements are listed in the accompanying table.
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.