What are we looking for?
Canadian small- and mid-cap stocks with reasonable valuations and growing earnings.
This week, I use Morningstar CPMS to look for companies in the small- and mid-cap space in Canada. Generally speaking, investing in smaller companies means greater risk (both in terms of volatility and liquidity risk), but may provide some great opportunities as well. The strategy first ranks stocks on the following three factors:
- Five-year earnings-per-share growth rate (on average, how much has the company grown their earnings each year in the past five years – higher figures preferred);
- Quarterly earnings momentum (the trailing four quarters of operating earnings compared with the same figure one quarter ago – higher figures preferred);
- Three-month price change (here we prefer companies with positive price momentum).
To qualify, companies must have a market capitalization between $125-million and $3.4-billion. These limits exclude the bottom one-third and top one-third of companies by market cap in the CPMS Canadian universe (today, this consists of 711 companies). In addition, qualifying stocks must have price-to-earnings, price-to-book and price-to-sales ratios in line with the sector to which the stock belongs. (For example, in the accompanying table, an industry relative P/E of 0.9 implies the company’s P/E ratio is 10-per-cent lower than that of the 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 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 December, 1993, to February, 2018. During this process, a maximum of 10 stocks were purchased and equally weighted. Once a quarter, stocks were sold if their rank fell below the top 40 per cent of the ranked universe, or if any of the above valuation metrics reached 30-per-cent above the sector median (signalling that the stock looks overvalued). When sold, the positions were replaced with the highest ranked stocks not already owned in the portfolio.
As a buffer to account for the less liquid nature of these names, a 1-per-cent liquidity cost was applied to each transaction (sold positions received 1-per-cent less and bought positions cost 1-per-cent more in each historical transaction).
Over this period, the strategy produced an annualized total return of 16.6 per cent while the BMO Nesbitt Burns Smallcap Total Return Index advanced 6.5 per cent. In calendar year 2017, this strategy produced 22.5 per cent while the benchmark gained 5.3 per cent.
Fourteen stocks currently meet our requirements for purchase and 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.