What are we looking for?
Momentum stocks that are undervalued relative to peers.
As the market breathes a slight sigh of relief on news that the latest variant of COVID-19 may not bring global economies to a screeching halt, optimistic investors may be looking for ideas that take advantage of recent market volatility and associated mispricing. To this end, today we look for Canadian-listed companies that show momentum characteristics, yet remain undervalued relative to sector peers. To create this strategy, I used Morningstar CPMS to first rank the 713 stocks in the Canadian database on the following factors:
- Sector relative price-to-earnings, price-to-sales, price-to-cash-flow and price-to-book (here we take various valuation multiples and compare them with the sector median – a figure of 0.9 in the table implies that the stock’s valuation multiple is 10 per cent lower than that of the sector);
- Three-month estimate revision on earnings per share (calculated as today’s median consensus estimate on earnings compared with the same figure at month end, three months ago);
- Quarterly earnings surprise (a comparison of the latest reported earnings per share against the consensus estimate on earnings just prior to the report);
- Three-month price momentum (calculated as the average price over the past six months as a percentage change from the average price over the six-month period ended three months ago);
- Market relative price change (the stock’s price movement over the past 12 months compared with the index; for example, STLC outperformed the index by 55 per cent over the past year);
- Trailing return on equity.
To qualify, at least one of the valuation metrics must be lower than the sector median. Additionally, only stocks with a market float greater than $100-million were considered, a figure meant to exclude the bottom one-third of the database by size. Recall that market float refers to the value of shares that are available for public trading.
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: @MorningstarCDN.
What we found
I used Morningstar CPMS to back-test the strategy from December, 1991, to November, 2021, assuming an equally weighted 15-stock portfolio with no more than three stocks an economic sector. Once a month, stocks were sold if they fell below the top 25 per cent of the universe based on the above metrics, or if all four of the valuation metrics listed exceeded 10 per cent of the sector median. 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 19.7 per cent, while the S&P/TSX Composite Total Return Index advanced 8.8 per cent. On a trailing 12-month basis, the strategy produced 54.8 per cent while the index gained 23.5 per cent. The stocks that meet requirements to be purchased into the strategy today are listed in the 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.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.