What are we looking for?
U.S.-listed companies that recently beat analyst expectations for earnings and have good cash flow.
Having a sufficient amount of cash on hand is important for a business in order to pay for operations on a continuing basis. It has been particularly important throughout the pandemic, as many businesses came under pressure and needed to adapt to extraordinary circumstances. Now that the economy is doing better we would expect companies to report stronger earnings, but it is equally important for a company to perform in line with the way that influential analysts expect it to. A miss on analyst expectations can have a negative impact on the stock price. A better-than-expected result can have the opposite effect.
Today I use Morningstar CPMS to look for mid-cap and large-cap companies that recently beat analyst expectations for quarterly earnings and have a history of generating good cash-flow momentum. This we capture using quarterly and annual cash-flow momentum, along with the three-year normalized (annualized) cash-flow growth. Quarterly and annual cash-flow momentum are calculated as the percentage change between the latest four quarters of reported operating cash flow per share and the same figure from one quarter ago, and one year ago, respectively.
I also included the five-year beta in order to reduce market risk. Beta is a commonly used volatility metric that compares the risk of a security to that of the overall market, in this case the S&P 500. A beta less than one means that the security is theoretically less volatile than the market. I also included a price momentum variable, called the price change to 12-month high, that has good downside protection. We’ve found that stocks that are trading close to their 12-month high tend to perform well.
The investment process started off with all 2,000 U.S.-listed stocks in our CPMS database. Then we ranked our stocks according to the quarterly earnings surprise, quarterly cash-flow momentum, annual cash-flow momentum and three-year normalized cash-flow growth.
Next, we applied these screens to create our list of stocks:
- Market capitalization above US$1.8-billion;
- Beta less than 1.3;
- Quarterly and annual cash-flow momentum greater than zero;
- Three-year normalized cash-flow growth greater than zero;
- Price change of less than 4 per cent from the stock’s 12-month high.
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, 2006, 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 an annualized total return of 14.3 per cent since inception whereas the S&P 500 Total Return Index generated 10.3 per cent. The strategy also produced a positive return in every calendar year since inception except for 2008. Today, the top 10 stocks that qualify for purchase into the strategy are listed in the accompanying table.
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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