What are we looking for?
Canadian companies with growing cash flow.
The Bank of Canada this week signalled it is set to launch a review of its approach to managing inflation; numerous alternatives under consideration include temporary periods of a higher target rate than the long-held 2 per cent.
As the great Warren Buffett has said, inflation is like a tapeworm that eats away at corporate earnings; as the company is required to spend more on receivables, inventory, fixed assets and the like, it becomes harder to convert that higher spending into retained earnings. This week, I look for companies that may provide some defence against higher inflation by targeting stocks with strong growing cash flow. I find these companies by ranking the stocks in the CPMS Canadian universe (today consisting of 700 companies) by the following metrics:
- Five-year cash flow growth rate (on average, how much cash flow has grown each year in the past five years);
- Quarterly and annual cash flow momentum (the latest four quarters of operating cash flows, compared with the same figure one quarter, and four quarters ago, respectively);
- Annual pretax return on capital (measures profitability of a company and relates a company’s pretax earnings to all the capital involved in the firm, including debt);
To qualify, companies must have cash flow-to-debt ratio greater than 0.2 times (a figure that represents the median ratio in the CPMS Canadian universe today).
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 October, 2018. During this process, a maximum of 20 stocks were purchased and equally weighted with a maximum of four stocks in a given economic sector. Once a month, stocks were sold if their rank fell below the top 35 per cent of the ranked universe or if analyst consensus estimates fell by more than 10 per cent over three months (not shown). When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Because there are some small-cap companies that were included in this analysis I’ve included a 1-per-cent liquidity cost (stocks are purchased for 1-per-cent higher and sold for 1-per-cent lower in the historical transactions).
Over this period, the strategy produced an annualized total return of 10.3 per cent while the S&P/TSX Composite Total Return Index rose 7 per cent. In the trailing 12 months, the strategy gained 4.5 per cent while the index lost 3.4 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.