What are we looking for?
Profitable U.S.-listed companies trading at a reasonable price-to-book value.
As the Nasdaq Composite Index climbs to new highs, investors are reminded that there is an element of concentration to this index that will leave the more conservative among us squirming: Microsoft Corp., Apple Inc. and Amazon.com Inc. make up 30 per cent of this index by weight. In combination, these three high-flying stocks have a trailing price-to-earnings ratio that is twice that of the S&P 500 index on an equally weighted basis.
Those of us who prefer to find companies that are trading at more reasonable valuations yet remain profitable might find ideas in today’s strategy, which ranks the 2,100 U.S.-listed stocks in the Morningstar CPMS database by:
- Average return on equity over the past five years (ROE is a profitability metric, higher values preferred);
- Standard deviation of ROE over the past five years (measures variability of return on equity, lower figures represent more consistency and are preferred);
- Price-to-book (a lower ratio is better).
To qualify, companies must have a sector-relative and historical-relative price-to-book ratio that is one or less. This would imply that stocks on the list have a price-to-book ratio that compares favourably with the sector to which it belongs, and with the stock’s own 10-year historical median price-to-book. Only companies with a market capitalization of US$2.8-billion or greater were included in the screen (meant to exclude the bottom half of the CPMS universe by size).
More about Morningstar
Morningstar Research Inc. is a leading provider of independent investment research in North America, Europe, Australia and Asia. Morningstar offers an extensive line of products and services for individual investors, financial advisers, asset managers, retirement plan providers and sponsors, and institutional investors. Morningstar Direct is the firm’s multi-asset analysis platform built for asset management and financial services professionals. Morningstar Canada on Twitter: @MorningstarCDN.
What we found
I used Morningstar CPMS to backtest this strategy from December, 1998, to June, 2020, using a maximum of 20 stocks with no more than five per economic sector. Once a month, stocks were sold if their rank dropped below the top 35 per cent of the database based on the factors listed above. Over this period, the strategy produced an annualized total return of 10.6 per cent while the S&P 500 Total Return Index advanced 6.4 per cent on the same basis. During the financial crisis, the strategy lost 34 per cent of its value while the index declined 51 per cent. Only 16 stocks meet the requirements to be purchased into the model today and are listed in the accompanying table.
This article does not constitute financial advice. It is always recommended to speak to a financial adviser or professional before investing in any of the securities shown here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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