What are we looking for?
A defensive strategy that protects on the downside.
The screen
Despite the U.S. equity market sell-off that investors have seen in recent trading periods, the S&P 500 index still sits at record highs, with valuations close to pre-2008 levels. Case in point, the median price-to-book ratio of the median stock in the United States today is about 2.4, a multiple eerily similar to what we saw in September, 2007.
For investors who are concerned about stubbornly high valuations, today’s strategy looks to add protection to a portfolio by looking for companies with a track record of quality and lower volatility. We find these stocks by ranking the 2,180 companies in the CPMS U.S. database by:
- Five-year average return on equity;
- Five-year variability of earnings (a statistical measure showing how consistent a company’s earnings have been over the past five years, lower figures preferred);
- Five-year beta (recall beta measures the historical sensitivity of a stock to an index. Companies with lower beta have moved less than the market when markets are falling or rising – here, we prefer lower figures);
- Dividend yield;
- Latest reported return on total assets.
To qualify, companies must have a market capitalization greater than US$1.7-billion. Additionally, stocks must pay a dividend and must have a payout ratio on earnings less than 80 per cent (to ensure sustainability of dividends).
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 December, 1998, to September, 2018. During this process, a maximum of 20 stocks were purchased and equally weighted with no more than four per sector. Once a month, stocks were sold if their rank fell below the top 35 per cent of the ranked universe, if consensus estimates dropped by more than 10 per cent or if the stock missed earnings expectations by more than 5 per cent. 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 9.4 per cent while the S&P 500 Total Return Index gained 6.5 per cent. Over this same period, there were 24 calendar quarters where the S&P 500 index produced negative returns. This strategy beat the index in 20 of those 24 quarters. In calendar year 2008, the strategy lost 16.4 per cent while the index lost 37 per cent.
The stocks that qualify for purchase today are listed in the table below. 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.
Ian Tam, CFA