What are we looking for?
Companies that are financially healthy and reinvesting their earnings for future growth.
As the stock market continues to reach new highs, it might be a good time for investors capitalizing on momentum to harvest at least some of those gains and move into “safer” stocks. This can enhance the downside protection in your portfolio by reducing solvency and liquidity risks. Morningstar has created a factor based on a quantitative health score to make it easier to determine whether a company is in good financial health. The methodology ranks companies on the likelihood that they will tumble into financial distress by using measures of leverage to estimate a firm’s “distance to default.”
Today I use Morningstar CPMS to look for Canadian companies that have a strong financial health score and the ability to reinvest their earnings. The reinvestment rate, based on the trailing earnings per share, is a good metric to find companies that are looking to grow their business, which can lead to stronger investment returns. This is calculated as EPS minus dividends divided by adjusted book value. I also factored in the return on equity (operating EPS as a percentage of the company’s average shareholders’ equity per share over the past year) because it is a good measure of financial performance. Lastly, I incorporated the standard deviation of a stock to reduce the price volatility in the portfolio and enhance risk adjusted returns. A larger standard deviation implies more volatility.
The investment process started off with all 700 Canadian stocks in our CPMS database. Then we ranked those stocks according to the Morningstar quantitative financial health score, trailing reinvestment rate, return on equity and the 180-day standard deviation.
Next, we applied four screens to those 700 stocks to create our list:
- Morningstar Quantitative Health Score in the top third (greater than 0.67);
- Reinvestment rate in the top third (greater than 5.2);
- Return on equity above 10 per cent;
- 180-day standard deviation below the median (less than 47).
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.
What we found
I used CPMS to back-test the strategy from January, 2012, to May, 2021. 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 18.8 per cent since inception whereas the S&P/TSX Composite Total Return Index generated 8.3 per cent.
Today, the top 10 stocks that qualify for purchase into the strategy are listed in the accompanying table. Readers should note that four small cap names are included, which may come with their own risks, such as illiquidity.
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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