What are we looking for?
Canadian small-cap stocks that have good short-term cash flow metrics.
With their potential to generate high returns, small-cap stocks can be a nice addition to one’s portfolio. But there are risks: Illiquidity is the obvious one, but there are business risks as well. Some of these companies might not have a long history of operational success and investors might not be confident in the long-term profitability of the company. Focusing on cash flow metrics can be a great way to assess the operational success of smaller companies.
Today I use Morningstar CPMS to look for small-cap companies that have good short-term cash flow momentum. Here, cash flow momentum is calculated on a quarterly and annual basis. Annual cash flow momentum is the rate of change between the latest four quarters of operating cash flow from operations per share and the same figure a year ago. Similarly, quarterly momentum is the rate of change between the latest four quarters of reported cash flow per share and the same figure from one quarter ago.
We want companies that have more cash flow in relation to debt because taking on excessive amounts of debt can be an operational risk when the economy slows down. We also incorporated beta to find companies that have less volatility than the S&P/TSX Composite Index. Beta measures the historical sensitivity of a stock to an index, in this case the S&P/TSX. In trending markets, a stock with a beta less than one has moved less than the index. Standard deviation is another metric that can help in finding stocks that have less volatility. This is calculated as the statistical variation of a stock’s return compared with its historical average. A lower value would provide more consistency. We also included enterprise-value-to-EBITDA, which is a popular metric used in corporate finance to assess the value of a company; a lower multiple would indicate a cheaper valuation. (EBITDA stands for earnings before interest, taxes, depreciation and amortization.)
The investment process started off with all 700 Canadian stocks in our CPMS database. Then we ranked our stocks according to market cap, beta, cash-flow-to-debt, annual and quarterly cash flow momentum.
Next, we applied four screens to create our list of stocks:
- Market capitalization above $65-million but below $2.4-billion;
- Cash-flow-to-debt multiple above 0.2;
- 180-day standard deviation below 46 per cent;
- Enterprise-value-to-EBITDA multiple less than 11.
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 June, 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 16.4 per cent since inception whereas the S&P/TSX SmallCap Total Return Index returned 3.5 per cent on the same basis. 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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