What are we looking for?
S&P 500 companies that show steady growth.
In the United States, COVID-19 case counts continue to rise, but you wouldn’t be able to tell by looking at the suspiciously quick, V-shaped recovery of the S&P 500 total return index. Those investors who are anxiously waiting for the other shoe to fall – yet can’t turn away from the outperformance of growth stocks – might look to this week’s strategy, which ranks the companies in the S&P 500 by:
- Five-year deviation of earnings and total returns (measuring the consistency of a company’s reported earnings, as well as the movement of the stock price, lower figures preferred to target lower volatility);
- Five-year historical beta (measures the historical sensitivity of the stock against the index. A stock with a beta less than one has historically moved less than the index in trending markets, lower figures preferred);
- Five-year average return on equity.
To qualify, the companies must also have a five-year earnings growth rate greater than that of the sector to which it belongs (in the accompanying table, a sector-relative measure of 1.2 per cent means that earnings have grown by 1.2 per cent faster than the median of the sector over the past five years). Additionally, only companies that have exceeded analyst expectations during their most recent reported quarter are included.
Finally, we also screen for companies with positive analyst sentiment by measuring the change in consensus estimates over the trailing three months. Here we only consider stocks where analysts as a group have revised their estimates upward.
The idea here is to look for growth companies that have a history of steady profitability and a low sensitivity to the index – a strategy targeted to the cautiously optimistic.
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 Morningstar CPMS to back-test this strategy from January, 2005, to June, 2020, using a maximum of 15 stocks with no more than three for every economic sector. Once a month, stocks were sold if they dropped below the top 25 per cent of the index based on the factors listed above, if analyst sentiment fell by more than 5 per cent or if the company missed earnings expectations by more than 5 per cent. Over this period, the strategy produced an annualized total return of 10 per cent, while the S&P 500 advanced 8.7 per cent on the same basis.
Although returns are important, it’s also prudent to consider how we got those returns. Did we take on excessive risk? One way to measure this is the Sharpe ratio, which compares the average monthly returns over the time period with the volatility of those returns. For reference, the Sharpe ratio of the strategy over the time period was 0.7 compared with 0.5 for the index, showing that we received a higher return for each unit of risk than the index.
Only 10 stocks meet the requirements to be purchased into the model today and they are listed in the accompanying table.
This article does not constitute financial advice. It is always recommended to speak with an adviser or financial professional before buying or selling any of the securities listed here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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