What are we looking for?
Solid, growth-oriented health-care companies.
So it finally happened. Cannabis is now legal for recreational use in Canada. And while we have seen great momentum stocks with lots of trading volume, investments in cannabis producers have been wrought with volatility, and have arguably lacked reasonable valuations and growth fundamentals from the perspective of a disciplined investor. Certainly a great ride, but likely not for everyone. For the significantly more traditional growth-oriented investor, I turn your attention to the broader health-care sector in the United States (today consisting of 250 companies in the CPMS U.S. database) to look for sound companies that have shown a reasonable history of growth. I find these companies by ranking the universe on:
- Five-year sales and earnings-per-share growth (on average, how much the top line and bottom line have grown each year in the past five years);
- Five-year average return on equity;
- Five-year variability of earnings (a statistical measure showing how consistent a company’s earnings have been over the past five years, lower figures preferred);
- Three-month estimate revision (today’s consensus estimate compared against the same figure three months ago);
- Quarterly earnings momentum (latest four quarters of earnings compared against the same figure one quarter ago).
To qualify, companies must have a market capitalization greater than US$1.2-billion (this figure removes the bottom one-third of stocks from our universe of 250 by size, to ensure reasonable liquidity).
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.With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to back-test this strategy from April, 2004, to September, 2018. During this process, a maximum of 10 stocks were purchased and equally weighted with no more than two for each sub-industry within the health-care sector. Once a month, stocks were sold if their rank fell below the top 35 per cent of the ranked universe, if consensus estimates dropped by more than 10 per cent or if the stock missed earnings expectations by more than 5 per cent. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 14.5 per cent while the S&P 500 Health Care Total Return Index gained 10.2 per cent. The stocks that qualify for purchase today (none of which pay a dividend) 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.