What are we looking for?
Smaller, reasonably valued Canadian companies with growing earnings.
This week, I use Morningstar CPMS to look for the lesser known (and sometimes thinly traded) companies that have shown growth in earnings and are not excessively overvalued. Smaller-cap companies are often volatile, but can be good diversifiers for a larger portfolio for investors that have a higher risk tolerance and a longer time horizon. To find these companies, I rank the stocks in the Morningstar CPMS Canadian database on the following metrics:
- Price-to-trailing-earnings, price-to-trailing-cash-flow and price-to-book ratios (value metrics, lower figures preferred, price-to-book not shown in table);
- Quarterly and annual earnings momentum (calculated as the trailing four quarters of operating earnings compared against the same figure one quarter and four quarters ago, respectively);
- Five-year earnings-per-share growth rate (on average, how much earnings have grown in each year over the last five years);
- Five-year deviation of earnings (not shown, a statistical measure showing the consistency of historical earnings, lower figures preferred).
To qualify, companies must have no more than two active analysts that cover the stock, and must have a monthly trading volume of at least 300,000 shares (this figure is meant to exclude the bottom one-sixth of companies in our database by liquidity). Note that in my strategy I’ve used all trailing metrics; forward-looking metrics are relatively scarce because these stocks are so thinly covered by sell-side research analysts.
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. With more than 120 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to back test this strategy from May, 1992, to January, 2019. During this process, a maximum of 15 stocks were purchased and equally weighted with no more than three per economic sector. Once a month, stocks were sold if their rank fell below the top 35 per cent of the ranked universe, or if a company’s return on equity turned negative (not shown). When sold, the positions were replaced with the highest ranked stock not already owned in the portfolio assuming a 1-per-cent liquidity cost (stocks were sold for 1 per cent lower than the close price and bought for 1 per cent higher – accounting for market movement in smaller, less liquid names). Over this period, the strategy produced an annualized total return of 14.6 per cent while the BMO Nesbitt Burns Small Cap Index gained 7.3 per cent.
Today, only 10 stocks qualify for purchase, ranked 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.