What are we looking for?
U.S. large-cap names that have shown a track record of consistent and growing earnings over the past 10 years, and are still trading somewhat close to their own historical valuations.
To find these companies, I use Morningstar CPMS to sort all stocks in the S&P 500 index on the following metrics:
- 10-year deviation in earnings (recall standard deviation is a measure of volatility, lower figures preferred);
- 10-year EPS growth rate (how much the company’s bottom line has grown each year, on average, during the past decade);
- 10-year average return on equity;
- Five-year price beta (a measure of sensitivity, in this case to the S&P 500. In trending markets, a beta less than one implies that the stock has moved less than the market, lower figures preferred);
To qualify to be purchased into the strategy, the company must have at least one of three valuation metrics (today I use price-to-sales, price-to-cash-flow and forward-price-to-earnings) that are at or below the stock’s own 10-year historical median. (In the table, a figure of 0.9 would imply that the company’s valuation metric is 10 per cent lower than its own 10-year median).
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 February, 2006, to September, 2019. During this process, a maximum of 10 stocks were purchased and equally weighted with no more than three per economic sector to ensure reasonable diversification across the economy. Once a month, stocks were sold if their rank fell below the top 35 per cent of the index, if all three valuation metrics were more than 10 per cent higher than the stock’s historical median, or if return on equity turned negative (not shown).
Over this period, the strategy produced an annualized total return of 12 per cent, while the S&P 500 registered a total return of 8.7 per cent. In the trailing 12-month period ended Sept. 30, the strategy produced 14.2 per cent while the index gained 4.3 per cent, on a total return basis.
The stocks that qualify for purchase today and 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.
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