What are we looking for?
U.S. small capitalization stocks that are increasing earnings.
As Canadian investors, home country bias is often a symptom that plagues our portfolios. Many studies have shown that a disproportional amount of Canadians’ equity holdings are of Canadian companies, which raises the question whether we as investors are reasonably diversified even within our own continent. For some ideas south of the border, this week I use Morningstar CPMS to look for lesser known companies (to Canadians) within the S&P SmallCap 600 that show a combination of the following characteristics:
- Quarterly earnings momentum (last four quarters of operating earnings compared against the same figure one quarter ago);
- Three-year EPS growth rate (on average, how much earnings have grown each year in the past three years);
- Three-month estimate revisions (today’s consensus estimate on fiscal earnings compared against the same figure three months ago);
- Variation of fiscal estimates (a statistical measure computing essentially the “spread” of analyst estimates or how consistent analyst opinions are at the moment, lower figures preferred);
- Five-year historical beta (recall beta measures the sensitivity of a stock to a benchmark index companies with a beta of less than one have historically moved less than the index in trending markets, lower beta preferred here);
To qualify, stocks must be part of the S&P SmallCap 600 and must have at least three active analysts covering the stock.
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 120 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 June, 2019. During this process, a maximum of 15 stocks were purchased and equally weighted with no more than four per economic sector. Once a month, stocks were sold if their rank fell below the top 35 per cent of the universe, or if estimates fell by more than 10 per cent over the trailing three months. 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 14.4 per cent while the S&P SmallCap 600 total return index gained 8.2 per cent. Of the 60 calendar quarters over this period, the index showed negative returns for 18 of them. Of those 18 negative quarters, our model outperformed the index in 15 quarters, or 83 per cent of the time.
The stocks that qualify for purchase today and 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.
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