What are we looking for?
Canadian stocks that appear to be undervalued, but may not be quite as attractive as they seem.
Most of the time we focus on stocks we should consider investing in, but in practice, it’s also very important to consider which stocks to avoid.
One common hazard is investing in currently undervalued stocks that one expects to increase (otherwise known as value stocks), but that instead continue to decline in price (commonly referred to as “value traps”). Value traps are both difficult to discern, as well as potentially dangerous for your portfolio. Even after they begin losing money, investors may continue to hold on to them in the hope that they will eventually rise, thereby potentially increasing their total loss.
Today, I’m showcasing a strategy that searches for possible value traps within the Canadian CPMS universe, which today holds 702 stocks. This is done by screening for stocks with a perceived low valuation, as well as positive price momentum, but with no additional risk/quality controls added on top, such as return on equity or beta. The purpose of this strategy is not to give ideas of stocks to purchase, but instead focus on stocks to avoid. This strategy ranks stocks as follows:
- Price to book value – lower values preferred;
- Quarterly earnings momentum, which measures the difference between the trailing four quarters of earnings per share (EPS) against the same metric lagged by one quarter – higher values preferred;
- Quarterly earnings momentum (next quarter), which gauges the trailing three quarters EPS and projected next quarter EPS, compared with the trailing four quarters EPS – higher values preferred;
- Revision in the three-month EPS estimate, which is the change in the median EPS estimate three months ago compared with now – higher values preferred;
- Quarterly earnings surprise, which is the difference between expected and actual reported EPS; higher values preferred.
In order to qualify, stocks must have: a price-to-book value in the lower half of peers (today this implies a value of 2.3 times or below), a quarterly earnings momentum greater than or equal to zero, and an average monthly value traded in the top half of peers (today this value is $11.1-million or above).
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.
What we found
I used Morningstar CPMS to back test this strategy from October, 2005, to December, 2019. During this process, a maximum of 20 stocks were purchased. Stocks were sold if the company’s quarterly earnings momentum declined below minus 7 per cent. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio.
One might expect a model that screens for undervalued stocks and good earnings momentum, etc., to perform well, but there is more to selecting good companies than just some of the more obvious metrics, such as low price-to-book and strong earnings surprise. Over this period, the strategy produced an annualized total return of 2.9 per cent, while the S&P/TSX Composite Index returned 6.6 per cent on the same basis. It’s also worth noting the model underperformed the benchmark in 85 per cent of down markets.
Only 17 stocks qualify for the strategy today and 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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