What are we looking for?
Canadian stocks that offer growth at a reasonable price.
The screen
A lot of investors prefer companies that use their earnings to reinvest in future growth opportunities. These are growth-oriented names that are suitable for those focused on capital appreciation. While many of these stocks will look expensive according to metrics such as price-to-earnings, we can still find companies that show earnings growth and the ability to reinvest those earnings, but are reasonably priced at the same time.
Today, I use Morningstar CPMS to look for large and medium-sized companies that are growth-oriented and have relatively low valuation metrics. The two fundamental valuation ratios that I used are the price-to-book and the forward price-to-earnings (calculated as the latest price per share divided by the median fiscal earnings-per-share estimate for a company’s current year).
The forward quarterly earnings momentum is meant to identify companies that are expected to report stronger earnings for the next quarter. It is calculated as the most recent three quarters of operating EPS, plus the estimated operating EPS for next quarter, compared with the most recent four quarters of operating EPS.
I used the variability of historical EPS in order to reduce the volatility in the portfolio by identifying companies that have shown more consistency in their reported earnings.
Lastly, I used the forward reinvestment rate to find companies that are using their income to finance the growth of their business. The rate is calculated as the estimated EPS, minus dividends per share expected to be paid in the next 12 months, as a percentage of the company’s adjusted book value per share.
The investment process started off with all 700 Canadian stocks in our CPMS database. Then we ranked our stocks according to the price-to-book, forward P/E, forward quarterly earnings momentum, variability of historical EPS and the forward reinvestment rate.
Next, we applied five screens to create our list:
- Forward reinvestment rate greater than 5 per cent;
- Variability of historical EPS below 20;
- Forward quarterly earnings momentum greater than minus 2.5 per cent;
- Market capitalization above $1.4-billion;
- Beta of 1.5 or less (stocks with a beta less than one have historically moved less than their comparable index).
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 CPMS to back-test the strategy from January, 2006, to August, 2021. During this process, a maximum of 10 stocks were purchased and equally weighted. The portfolio was rebalanced monthly and the strategy produced a total return of 13.2 per cent since inception whereas the S&P/TSX Total Return Index advanced 6.6 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