What are we looking for?
A portfolio of U.S. stocks with robust balance sheets.
Equity analysts often make references to different ratios used to determine why a stock is a good purchase or not. These ratios consist of information derived from many different sources, one of which is a company’s balance sheet.
The balance sheet is a statement outlining a company’s assets, liabilities and shareholder equity. Analysts use the information available in this statement to help make their decision surrounding whether that company is a worthwhile investment.
Today’s strategy is going to look for companies with strong balance sheets in the CPMS U.S. universe, currently made up of 2,100 names. This strategy ranks stocks based on return on invested capital (ROIC) – a profitability metric (high values preferred) and cash flow/debt (high values preferred).
In order to qualify, stocks must have:
- Debt-to-equity ratio less than or equal to 1.1, to remove highly leveraged companies
- Debt-to-total assets ratio (a measure of leverage) in the lower two-thirds of peers – today this equates to a value of 0.40 or lower
- Cash flow-to-debt in the top two-thirds of peers – today this equates to a value of 0.27 or higher
- Market capitalization in the top two-thirds of peers in order to remove any micro-cap stocks – today this equates to a value of $1.77-billion or higher
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 110 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 April, 2004, to December, 2019. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their debt-to-equity rose above 1.3 or if their cash flow-to-debt fell in the bottom 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 13.7 per cent while the S&P 500 Total Return Index returned 9.3 per cent. 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, director, CPMS sales, at Morningstar Research Inc.
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