What are we looking for?
U.S. companies with lower volatility and strong cash-flow metrics.
The screen
It has been a year for the record books, and with the surge in coronavirus cases and the upcoming U.S. presidential election it doesn’t look as though 2020 is going to quiet down soon. As for the election, the results will very likely work their way into the stock market as they have so often in the past. With this in mind, it may be worthwhile reviewing your investments and seeing whether you are well set up for any impending shakeups.
Today’s strategy is searching for U.S. stocks that are more likely to protect your capital during down markets. The universe we’re using is the S&P 500 index and this strategy ranks stocks based on:
- Three-year beta, which measures a company’s sensitivity relative to historical changes in the benchmark. In trending markets, a stock with beta less than one has historically moved less than the index – lower values preferred;
- Earnings variability, which measures how volatile a company’s earnings are over the past five years – lower values preferred;
- The latest four quarters’ free cash flow per share, higher values preferred.
Stocks that qualify must have:
- Earnings variability in the lower half of peers (this value today is 8.4 per cent or less);
- Market capitalization in the top two-thirds of peers (today this value is US$13-billion or higher);
- Long term debt-to-equity (a measure of liquidity) less than or equal to 1.2 to ensure companies don’t have excessive debt on hand;
- Free cash flow in the latest four quarters that is in the top third of peers (today this value is US$6.27 a share or higher).
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 September, 2020. During this process, a maximum of 20 stocks were purchased. Stocks were sold if their earnings variability rose into the highest half of peers or their latest four quarters of free cash flow fell into the lowest half of peers. 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 10.6 per cent while the S&P 500 Total Return Index advanced 9.2 per cent. It’s also worth noting that out of all the months the S&P 500 had negative returns, the model outperformed 76 per cent of the time.
Stocks that qualify for purchase into the strategy today 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.
Emily Halverson-Duncan, CFA, is a director, CPMS sales at Morningstar Research Inc.
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Emily Halverson-Duncan, CFA