What are we looking for?
S&P 500 names trading below historical valuations that show competitive barriers to entry.
This week, I use Morningstar CPMS to look for companies in the S&P 500 that appear to be trading near or below their historical valuations, while maintaining a “narrow” or “wide” economic moat rating from Morningstar’s team of equity research analysts. For those unfamiliar, each stock covered by Morningstar analysts is given an economic moat rating, signifying the company’s ability to produce return on invested capital above its own cost of capital.
Morningstar’s analysts see five distinct sources of economic moat: network effect (when the value of a company’s service increases for new and existing users as more people use the service); intangible assets (such as patents, brands, regulatory licences); cost advantage (for example, be able to undercut competitors on price while earning similar margins); switching costs (when it would be too troublesome to stop using a company’s products); and efficient scale (when a niche market is effectively served by one or a small handful of companies).
In addition to the Morningstar moat rating, I rank stocks on the following metrics:
- Five-year earnings-per-share and sales-growth rates (on average, how much has the company grown its top and bottom lines each year in the past five years -- higher figures preferred);
- Price-to-earnings, price-to-sales and price-to-book ratios relative to the stock’s own 10-year historical median (in the accompanying table a figure of 0.9 signifies that the company’s current valuation is 10 per cent lower than its own historical median valuation – lower figures preferred).
- Five-year EPS variability (a statistical measure showing how consistent a company’s earnings have been over the last five years -- lower figures preferred).
To qualify, companies must be part of the S&P 500 Total Return Index.
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 April, 2004, to February, 2018. During this process, a maximum of 20 stocks were purchased and equally weighted with no more than four stocks per economic sector. Once a month, stocks were sold if their rank fell below the top 40 per cent of the ranked universe. 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 12.2 per cent while the S&P 500 Total Return Index advanced 8.9 per cent. In calendar year 2017, this strategy produced 25.5 per cent while the benchmark gained 21.8 per cent.
The stocks that meet our requirements for purchase are listed 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.