What are we looking for?
Canadian stocks with low or declining debt and positive cash flow.
Across their lifespan, companies look to many different sources to acquire capital in order to grow their business. The most common sources are raising cash through offering shares (equity) and taking on debt. While both can offer significant benefits to firms, they also have their own drawbacks. Debt, for example, when taken on in large quantities, can be difficult for firms to pay down and can eat away at a lot of their free cash flow, which is a potential risk to a firm’s solvency.
In today’s Number Cruncher, I’m showcasing a strategy that looks for firms with low or decreasing debt as well as excess cash flow in order to avoid companies with debts so high they cannot properly manage them.
The strategy ranks stocks based off of debt-to-equity (a liquidity measure, low values are preferred) and quarterly cash-flow momentum (measured as the growth in most recent trailing four quarters of cash flow relative to the trailing four quarters of cash flow lagged by one quarter, high values preferred).
In order to qualify, stocks must have:
· A debt-to-equity ratio less than 1.1 (to ensure companies are not overleveraged);
· A cash-flow-to-debt ratio (trailing four quarters' cash flow relative to long-term debt) in the top one-third of peers – today this value is 0.42 or higher (figures for companies with no debt are shown as “n/c,” or not calculable);
· One-year debt-buyback (measures the amount of debt a company has repurchased) greater than or equal to zero;
· Quarterly cash-flow momentum greater than or equal to zero;
· Five-year annualized cash flow growth greater than 50 per cent of peers (today this value is 5.2 per cent);
· Five-year beta (measures a company’s sensitivity relative to changes in the benchmark – here we use the S&P/TSX Composite Index) must be less than or equal to one.
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 November, 2001, to July, 2018. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their debt-to-equity rose above 1.5 or if their five-year cash-flow growth declined below zero. 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 14.6 per cent while the S&P/TSX Composite Total Return Index returned 7.7 per cent across the same period. It is also worth noting that this strategy outperformed the benchmark in 91 per cent of down markets (defined as quarters the benchmark returns less than zero). 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.