What are we looking for?
U.S. large-cap value stocks.
Value strategies look for stocks that are currently undervalued relative to what you would expect them to be worth. Of the many ways to uncover value stocks, one of the most common is to look for companies with a low price-to-earnings ratio compared with their peers. A low P/E indicates that a company is trading at a lower price than its peers per one dollar of that company’s earnings. While this will not guarantee that company’s shares will increase to the price point you believe they’re worth, it can serve as a good starting point for isolating better-valued stocks.
Today, I’m showcasing a strategy that is searching for value stocks within the CPMS U.S. universe, which today comprises 2,141 companies. This strategy ranks stocks using the following factors:
• Price-to-trailing-earnings – measured as the company’s most recent share price divided by the most recent four quarters’ earnings per share, lower values preferred;
• Free cash flow – a profitability metric measuring the most recent four quarters of free cash flow per share, higher values preferred;
• Price-to-trailing-cash-flow, which is the company’s most recent share price divided by the trailing four quarters of cash flow per share, lower values preferred.
In order to qualify, stocks must have both a trailing P/E in the bottom half of all U.S. stocks (that value today is 24.23 or below). To ensure companies are not overextended, they must have a debt-to-equity ratio of no more than 1.1. Stocks must also have a market capitalization in the top half of peers (that value today is roughly US$3.3-billion 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 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 August, 2019. During this process, a maximum of 15 stocks were purchased. No more than four stocks could be held in any one sector at any given time. Stocks were sold if the company’s debt-to-equity ratio grew to more than 1.3. 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 11.9 per cent while the S&P 500 Total Return Index advanced 8.8 per cent over the same period.
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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