What are we looking for?
Value-oriented stocks within the Canadian universe.
Looking for undervalued companies continues to be a popular method of selecting stocks, best known as value investing. The concept was originally introduced by Benjamin Graham and David Dodd and has since become a well-recognized investment style in part thanks to its advocacy by investors Peter Lynch and Warren Buffett. Recall that the purpose of value investing is to select stocks that are currently trading for less than what you believe they are worth.
Today’s strategy searches for value stocks within the CPMS Canadian universe, which today holds 700 names. The strategy ranks stocks based on the following criteria:
- Price-to-trailing earnings (measured as the company’s most recent share price divided by the previous four quarters’ earnings per share, low values are preferred);
- Price-to-book value (measured as the company’s most recent share price divided by the book value per share; low values are preferred);
- Five-year beta relative to the S&P/TSX Composite Index (measures a company’s sensitivity relative to changes in the benchmark – a value less than one would indicate the stock is less volatile than the market, low values are preferred;
- Price-to-trailing-cash flow (the company’s most recent share price divided by the most recent four quarters of operating cash flow, low values are preferred).
In order to qualify, stocks must have a market cap greater than $150-million; a trailing P/E in the bottom half of all Canadian stocks (that value today is 17.2 times or below); a P/B in the bottom half of all Canadian stocks (that value today is 1.4 or below); and a payout ratio (calculated as dividends per share divided by earnings per share) less than 80 per cent to ensure earnings were not all being paid out as dividends.
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.
What we found
I used Morningstar CPMS to back-test this strategy from December, 1985, to May, 2019. During this process, a maximum of 10 stocks were purchased. Stocks were sold if the company’s payout ratio rose above 80 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 13 per cent while the S&P/TSX Total Return Composite Index returned 8 per cent across the same period.
Readers will see that a number of the stocks in the accompanying table have taken a hit over the past 12 months. Indeed, the Dow Jones Canada Select Value Index has lost 3 per cent over the past year, indicating value stocks in general have not been in favour. However, it’s worth noting this strategy has lost 1.5 per cent over the same time frame, suggesting the use of the buy and sell criteria showcased in our model can help to stabilize returns in a rough market for value investing.
Stocks that qualify for purchase into the strategy today are listed in the table. As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed below.
Emily Halverson-Duncan, CFA, is a director, CPMS sales at Morningstar Research Inc.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.