What are we looking for?
Profitable Canadian companies generating real cash.
Let’s hope the past week’s price action on stocks such as GameStop Corp. has served only as a source of entertainment for the readers of this column. Though the possibility of reaping outsized returns over mere days is tempting, experienced investors know that there is no free lunch – an unfortunate lesson learned by recent shareholders of GameStop on Tuesday.
Perhaps as a break from the noise generated by this excitement, today we look for Canadian-listed companies that have the potential to produce reasonable returns over time, backed by their proven ability to produce profits and generate cash. To find these companies, I ranked the 221 companies in the S&P/TSX Composite Index on the following factors:
- Five-year earnings growth rate and cash flow growth rate (both measuring how much, on average, earnings and operating cash flow have grown each year in the past five);
- Five-year average return on equity (a profitability metric, averaged over the past five years);
- Annual cash flow momentum (the past four quarters of operating cash flow compared with the same figure four quarters ago, higher values preferred);
- Five-year standard deviation of return on equity (a measure of consistency, lower values preferred).
What we found
I used Morningstar CPMS to back-test this strategy from April, 1995, to January, 2021, using a maximum of 15 stocks with no more than four per economic sector. Once a month, stocks were sold if they fell below the top 25 per cent of the index based on the aforementioned metrics and replaced with the highest ranking stock not already held in the portfolio. On this basis, the strategy produced an annualized total return of 12.1 per cent, while the S&P/TSX Composite Total Return Index advanced 8.2 per cent. All this said, the strategy is not without risk – in March, 2020, the strategy lost 21.5 per cent while the index lost 17.4 per cent. Over the full 2020 calendar year, the strategy gained 9.4 per cent while the index gained 5.6 per cent.
The stocks that meet the requirements to be purchased today are listed in the accompanying table. This article does not constitute financial advice. It is always recommended to speak with a financial adviser or professional before investing.
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.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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.