What are we looking for?
Beaten-down stocks showing signs of longer-term profitability.
As rocky equity markets continue to worry those who look at their portfolios all too often, the S&P/TSX Composite Total Return Index has posted year-to-date losses totalling 4.5 per cent. For the optimistic investor, the recent negative market action might present some buying opportunities. To borrow from Warren Buffett, “be fearful when others are greedy, and greedy when others are fearful.” With his in mind, today I use Morningstar CPMS to look for companies whose share price has declined significantly on a year-to-date basis, but show signs of longer-term profitability and positive analyst sentiment.
Experienced investors will quickly realize this is not really a Buffett-like approach, but rather one that focuses on fundamental growth (as opposed to deep value, which Mr. Buffett has historically been known for). Nevertheless, today’s strategy starts by ranking the 701 stocks in the CPMS Canadian database on the following measures:
- Five-year average return on equity and forward ROE (the latter using the median consensus Street estimate for earnings for calculation, higher figures preferred in both cases);
- Five-year earnings per share and operating cash flow growth rates (on average, how much earnings and cash flow have grown in each year over the past five, higher figures preferred);
- Three-month EPS estimate revision (today’s median Street estimate on EPS, compared against the same figure as it appeared at month-end, three months ago. Higher figures preferred).
To qualify, stocks must have a market capitalization great than $140-million, a figure meant to exclude the bottom one-third of stocks in the database by size. Additionally, only stocks that show a year-to-date total return of minus 8.3 per cent or worse were considered (this figure is meant to look for companies in the bottom half of our database in terms of year-to-date total return).
What we found
I used Morningstar CPMS to back-test the strategy from November, 2002, to April, 2022, assuming an equally weighted 15-stock portfolio with no more than four stocks per economic sector. Once a month, stocks were sold if they fell below the top 35 per cent of the universe based on the above metrics, or if analyst EPS estimates fell by more than 15 per cent. When sold, stocks were replaced with next qualifying stock not already held in the portfolio, considering the aforementioned sector limits. On this basis, the strategy produced an annualized total return of 14.6 per cent, while the S&P/TSX Composite Total Return index advanced 9.1 per cent on the same basis. The stocks that meet requirements to be purchased into the strategy today are listed in the accompanying table.
This article does not constitute financial advice. Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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