What are we looking for?
Canadian-listed stocks that combine value, momentum and quality.
In a cyclical market such as Canada, being a purely value-based investor is often a challenge owing to the influence of commodity prices that drive a large portion of the Canadian economy. Remember that the materials and energy sectors together make up almost 30 per cent of the S&P/TSX Composite Index. Swings in supply and demand of said commodities often come with volatility in the stock price, even if a company is considered undervalued fundamentally. A more suitable strategy may be to combine value, momentum and quality metrics together to find stocks that are less likely to fall into a value trap.
This week, I use Morningstar CPMS to rank the stocks in our Canadian universe (today consisting of 703 companies) on a combination of the following metrics:
- Value: price-to-earnings, price-to-book and price-to-sales ratios relative to the stock’s own 10-year median (in the table, a value of 0.9 means that the valuation metric is 10-per-cent lower than its 10-year historical median);
- Momentum: price change from 12-month high (in the table a figure of minus 3 per cent, for example, would indicate the company is trading 3 per cent below its 52-week high, higher figures preferred here), and six-month price change (higher figures preferred);
- Quality: Five-year average return on equity and five-year deviation of earnings (a safety metric measuring how volatile a company’s earnings have been over the last five years, lower figure preferred, not shown).
To qualify, companies must have a market cap greater than $1-billion (this figure is meant to exclude the bottom two-thirds of companies in Canada by size), and must have a positive trailing return on equity (not shown). Unit trusts were excluded in this analysis.
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 May, 1992, to June 2019. During this process, a maximum of 15 stocks were purchased and equally weighted with no more than three per economic sector to ensure reasonable diversification across the economy. Once a month, stocks were sold if their rank fell below the top 35 per cent of the universe, if consensus earnings estimates fell by more than 10 per cent over the trailing three months (not shown), or if the company reported a negative return on equity.
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 13.8 per cent while the S&P/TSX Composite Total Return Index gained 8.6 per cent. The maximum drawdown (the percentage change in the portfolio value, measured from peak to trough over consecutive months) for the portfolio was minus 26.1 per cent (October, 2007, to February, 2009) while the maximum drawdown for the index was minus 43.4 per cent (May, 2008, to February, 2009), which speaks to the defensive nature of this model.
The stocks that qualify for purchase today are listed in the accompanying table. It is always recommended to speak to a financial adviser or investment professional before investing.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.
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