What are we looking for?
S&P 500 stocks with growth characteristics.
When managing your investments, there is usually some desire to mitigate risk while still maintaining reasonable levels of growth. While there are many methods you can use to help you reduce risk, one simple step is to focus on larger companies with a long track record of success.
Larger firms also tend to be more recognizable names, which can give investors a sense of comfort when choosing where best to invest their money.
Today I’m showcasing a strategy that looks for growth companies within the universe of the S&P 500, an index comprising the 500 largest U.S. publicly traded companies. This strategy ranks stocks using the following factors (higher values preferred in all cases):
- Trailing return on equity (ROE) – a profitability metric;
- Five-year sales growth – annualized measure of a company’s growth in sales;
- Annual cash flow momentum – the change between the trailing four quarters of cash flow compared with the same metric one year ago;
- Quarterly cash flow momentum – the trailing four quarters of cash flow compared with the same metric one quarter ago;
- Quarterly earnings momentum – the trailing four quarters’ earnings per share (EPS) compared with the same metric one quarter ago.
In order to qualify, stocks must have a trailing ROE and quarterly cash flow momentum in the top third of peers – today this has a minimum value of 31.8 per cent or 2.8 per cent respectively. Quarterly earnings momentum and quarterly earnings surprise (the difference between a company’s expected and posted quarterly EPS) are required to be positive. Lastly, to help control volatility, there is a cap on a company’s five-year earnings variability (how unpredictable a company’s reported EPS are – a lower value indicates their quarterly earnings are relatively stable) requiring stocks to be in the lower half of peers – today this is a value 11 per cent or lower.
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.
What we found
I used Morningstar CPMS to back test this strategy from January, 2006, to July, 2020. During this process, a maximum of 15 stocks were purchased. Stocks were sold if the company’s trailing ROE fell into the bottom third of peers or if their five-year EPS variability rose into the top third of peers. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 12.4 per cent while the S&P 500 Total Return Index advanced 8.9 per cent on the same basis.
It’s also worth noting that, compared with same model using all U.S. stocks as a universe, the S&P 500 model outperformed in 94 per cent of down markets (defined as quarters that the benchmark posts negative returns), showcasing its superior downside protection.
Stocks that qualify for purchase into the strategy today 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.
Emily Halverson-Duncan, CFA, is a director, CPMS sales at Morningstar Research Inc.
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