What are we looking for?
Canadian stocks beating the market but still cheap relative to peers.
Year-to-date, the S&P/TSX Composite Total Return Index has risen 16.1 per cent, a spectacular display of the market’s resiliency as Canada continues to loosen pandemic-related restrictions. That said, the impressive performance of our equity index continues to raise the question whether we are overpaying for sought-after stocks on a tear. To this end, today I use Morningstar CPMS to look for companies that have indeed outperformed the index yet still appear undervalued relative to their peers. To find these stocks, I first ranked the largest 250 companies in the Morningstar CPMS Canadian database (excluding unit trusts) on the following momentum factors:
- Three-, six- and nine-month price change (higher values preferred);
- Three-, six- and nine-month market-relative price change (here the market is represented by the S&P/TSX Composite Total Return Index. In the table, a value of 16.6, for example, implies that the stock has outperformed the index by 16.6 per cent, higher values preferred).
I also observed the stocks’ sector-relative price-to-earnings, price-to-sales, price-to-book and price-to-cash-flow ratios to look for companies with multiples below their peers (in the table, a sector relative P/E ratio of 0.6 implies that the company’s P/E ratio is 40-per-cent lower than that of the sector to which it belongs). To qualify, only one of the four valuation ratios must be lower than the sector (i.e. lower than 1.0). As a quality check, I also placed a screen on the company’s five-year average return on equity such that it is positive, to ensure companies that show up have been profitable.
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What we found
I used Morningstar CPMS to back-test the strategy from December, 1990, to June, 2021, assuming a 15-stock portfolio that never holds more than four stocks per economic sector. Once a month, stocks were sold if they fell below the top 35 per cent of the universe based on the aforementioned metrics, or if all four of the valuation metrics mentioned above exceeded the sector median by 10 per cent or more, that is, higher than 1.1. When sold, stocks were replaced with next qualifying stock not already held in the portfolio, keeping in mind the sector limits.
The strategy produced an annualized total return of 15.3 per cent, while the S&P/TSX Composite Total Return Index advanced 8.9 per cent on the same basis. Investors are reminded that momentum-oriented strategies like this one often come with an abundance of trading, which can be taxing to an investor not prepared to pay close attention to the portfolio. Case in point, over the test period the strategy exhibited an average portfolio turnover of 204 per cent, implying that each of the 15 stocks in the portfolio were replaced twice a year, on average. If we were to assume a fairly aggressive trading commission of 5 cents a share over the course of the test period, the annualized return drops down to 14.1 per cent annualized, still well ahead of the benchmark.
Only 14 stocks qualify to be purchased into the strategy today and they are shown in the accompanying table. This article does not constitute financial advice. It is always recommended to speak with a financial adviser or professional before investing.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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