What are we looking for?
U.S. growth stocks with fundamentally higher reinvestment rates and earnings momentum.
The S&P 1500 Pure Growth index has generated a 41.2-per-cent total return over the past year, as of Sept. 30, outperforming the S&P 500 by 11 percentage points. (Pure Growth index constituents are drawn from the S&P Composite 1500, which combines the S&P 500, S&P MidCap 400 and the S&P SmallCap 600.)
The Pure Growth index attempts to capture growth by incorporating sales, the ratio of earnings change to price, and momentum. A lot of investors are interested in these companies because they’re expected to grow faster by reinvesting in their business so they can expand.
Today, I use Morningstar CPMS to look for companies of all sizes that are focused on expanding their business through higher earnings and reinvestment rates. We use the forward reinvestment rate as a measure of a company’s profitability. This is the rate at which a company is expected to reinvest earnings back into the business and is a common measure of a company’s growth. For example, a value of 18 per cent indicates a company’s book value growth based on returned earnings is expected to be 18 per cent in the current fiscal year.
We also used another version of the reinvestment rate, which is based on the median analyst estimate for next year’s earnings per share (EPS).
We used three different metrics to find companies that have higher earnings momentum. The first is annual earnings momentum, which is calculated as the latest four quarters of operating EPS compared with the same figure from one year ago. The second is next year’s median analyst estimate for the annual EPS growth rate, and the third is the average EPS growth rate over the past three years.
Lastly, we used the Morningstar Quantitative Financial Health Score to identify companies that have strong balance sheets, with 1.0 being the highest possible score. This is a proprietary metric that measures the probability that a firm will fall into financial distress or default on its financial obligations.
The investment process started off with all 2,000 U.S. stocks in our CPMS database. Then we ranked our stocks according to the forward reinvestment rate, the reinvestment rate based on next year’s median analyst estimate for EPS, the median estimate EPS growth rate next year, and the three-year EPS growth rate. Based on these factors, our model is broadly in line with the S&P 1500 Pure Growth index.
Next, we applied three screens to create our list of stocks:
- Annual earnings momentum above 10 per cent;
- Three-year EPS growth rate above 15 per cent;
- Morningstar Quantitative Financial Health Score ranked in the top third on our list of 2,000 stocks.
What we found
I used CPMS to back-test the strategy from February, 2007, to September, 2021. During this process, a maximum of 20 stocks were purchased and equally weighted. The portfolio is rebalanced monthly and the strategy produced a total return of 16.8 per cent since inception, whereas the S&P 500 Total Return Index advanced 10.2 per cent. Today, the top 20 stocks that qualify for purchase into the strategy 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.
Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
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