What are we looking for?
Large U.S. companies that have a strong competitive advantage and solid earnings momentum.
Companies with robust business models and superior fundamentals can provide higher returns with lower downside risks. Many equity analysts use Porter’s Five Forces of competition (named after Michael Porter of Harvard Business School) to identify companies that able to provide more consistent investment returns because they’re able to produce goods and services more efficiently than competitors. The theory looks at the number of competitors; strong barriers that prevent competitors from gaining market share; suppliers with less ability to influence costs; customers with less ability to negotiate lower prices; and whether there are few substitute products.
Similar to Porter’s Five Forces, the Morningstar Economic Moat Rating uses a methodology to assess whether a company has a sustainable competitive advantage that will allow it to generate profits and excess returns that will last more than 10 years. We used annual earnings momentum, quarterly earnings momentum and the forecast for next quarter’s earnings momentum to find companies that are growing their bottom line.
It’s also important for these companies to consistently report good earnings, so we use the historical earnings variability to find lower volatility in reported earnings per share. Return on equity can help us focus on companies with good internal financial performance; the reinvestment rate to make sure that these companies are successfully reinvesting in their businesses for future growth.
The investment process started off with all 2,009 stocks in our U.S. database. Then we ranked our stocks according to the Morningstar Economic Moat Score, reinvestment rate, annual earnings momentum, quarterly earnings momentum and next quarter’s estimate for earnings momentum.
Next, we applied these screens to create our list of stocks:
- Market capitalization greater than US$9-billion;
- Morningstar Economic Moat Score of five, which indicates a wide moat (a narrow moat is three, no moat is zero);
- Reinvestment rate above 20 per cent (calculated as the trailing earnings per share less trailing dividends per share as a percentage of the company’s adjusted book value per share);
- Historical earnings variability less than 19 per cent, a reading that would indicate more consistent earnings over time relative to most stocks;
- Next quarter’s estimate for earnings momentum that is greater than zero. This compares the three quarters of trailing operating EPS plus the estimated EPS for next quarter with the four quarters of trailing operating EPS.
What we found
We used CPMS to back-test the strategy from January, 2006, to March, 2022. 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 15.4 per cent since inception, whereas the S&P 500 Total Return Index advanced 10.3 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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