What are we looking for?
Canadian-listed small- and mid-cap value stocks.
Investors who use the value style of investment management hope that the stock price will rise as more people come to appreciate the true value of the company’s fundamental business. Using this approach with small- and mid-cap stocks can also diversify your portfolio by adding stocks that are less correlated with large caps. In addition to the diversification benefits, small companies tend to rebound from a recession faster than larger ones because they can respond much more quickly to a positive economic environment.
Today I use Morningstar CPMS to look for small- and mid-cap Canadian companies that have lower price-to-earnings and price-to-cash-flow ratios than the S&P/TSX Composite Index. (Our database shows the index’s P/E at 19.9 and price-to-cash-flow at 9.2.)
To be included on the short list, the stocks need to have a beta of less than two in an attempt to eliminate stocks whose prices move a lot more than the S&P/TSX. (Beta is a measure of volatility: A stock that swings more than the market has a beta above one; stocks with a beta less than one have historically moved less than the index.)
Quarterly free cash flow momentum is an important factor that shows how much cash a company has left over after paying for operational and capital expenditures.
The industry-relative debt-to-equity ratio can help us identify companies that have less leverage compared with others in their peer group. This is calculated as the company’s debt-to-equity divided by the industry median. So, for example, a company with a ratio of 0.9 would imply that its debt-to-equity is 10 per cent lower than the median of the industry to which it belongs.
We are also looking for a higher return on equity, a common measure of financial performance that shows how profitable a company is in relation to the shareholders’ equity. The final factor is the price change from the 12-month high, because we’ve found that stocks that are trading close to their 12-month highs tend to perform well. This is a momentum factor that has shown really good downside protection.
The investment process started off with all 700 Canadian stocks in our CPMS database. Then we ranked our stocks according to the trailing P/E, price-to-cash-flow, beta and quarterly free cash flow.
Next, we applied four screens to create our list of stocks:
- Market capitalization less than $10-billion;
- Industry relative debt-to-equity of less than four;
- Return on equity greater than 10 per cent – in other words, in the top third of stocks in the S&P/TSX;
- Price change of less than 10 per cent from the stock’s 12-month high.
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.
What we found
I used CPMS to back-test the strategy from January, 2006, to April, 2021. During this process, a maximum of 10 stocks were purchased and equally weighted. The portfolio is rebalanced monthly and the strategy produced an annualized total return of 18.3 per cent since inception whereas the S&P/TSX Total Return Index advanced 7.7 per cent on the same basis. The strategy also outperformed the index over every single calendar year since inception except for one (2018). Today, the top 10 stocks that qualify for purchase into the strategy 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.
Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
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