What are we looking for?
Companies that are managing their ESG risks well and reinvesting their earnings for growth.
The screen
Investors’ growing interest in environmental, social and governance issues is a quickly evolving trend. Climate change, for example, will be one of the most economically impactful events in human history. The costs of climate change have a wide range, with some estimates of the value at risk, or possible financial losses, of climate change on global manageable assets at US$4.2-trillion.
Evidence suggests that material ESG issues can have a significant impact on equity returns and the COVID-19 pandemic has led more investors to consider ESG information such as social and environmental metrics in their investment processes.
Today I use Morningstar CPMS to look for Canadian companies that are less controversial because they are good at managing ESG risks in addition to being able to reinvest their earnings into future growth opportunities. I used an ESG Controversy Level (scores of zero to five – five indicating highest risk) created by Sustainalytics of more than 35,000 sources to determine stakeholder or reputational risk after an event that was reported in the news. I paired that with Sustainalytics ESG Risk Rating, which measures a company’s exposure to and management of material ESG issues.
In addition, I used the trailing reinvestment rate to find companies that are putting more money into growing their businesses with emphasis placed on sectors that have higher forecast reinvestment rates. Another metric, a company’s price-to-earnings relative to its earnings growth, will help ensure we are not paying too much for the growth of those earnings.
Lastly, I incorporated two metrics for strong financial performance and momentum. Three-year average return on equity will help us find companies that are better at managing their leverage while generating higher profitability and return on assets. In terms of momentum, our research tells us that stocks trading close to their 12-month high tend to continue performing well and provide 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 following criteria: three-year average return on equity, trailing reinvestment rate, forecast industry median reinvestment rate and the P/E relative to the growth of those earnings.
Next, we applied five screens to create our list of stocks:
- Market capitalization above $260-million;
- ESG Controversy Level score of zero;
- Overall ESG Risk Rating lower than 28 (out of 100), which is the median for all Canadian stocks in our database;
- Three-year average return on equity above 10 per cent;
- Price change of 20 per cent or less from the stock’s 12-month high.
More about Morningstar & Sustainalytics
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. Sustainalytics, a Morningstar company, is a leading ESG research, ratings and analytics firm that supports investors around the world with the development and implementation of responsible investment strategies. Morningstar Canada on Twitter.
What we found
I used CPMS to back-test the strategy from June, 2012, to July, 2021. During this process, a maximum of 10 stocks were purchased and equally weighted. The portfolio is rebalanced monthly and the strategy produced a total return of 20.3 per cent since inception whereas the S&P/TSX Composite Total Return Index generated 9.6 per cent. 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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Phil Dabo, MFin