What are we looking for?
Lesser-known Canadian-listed stocks that are increasing earnings and cash flow.
It is no surprise that during the pandemic sell-off, small cap stocks, which are often more volatile in nature, saw significant drawdowns. Case in point, the S&P/TSX SmallCap Index lost 46.6 per cent of its value on a total return basis during the sell-off, while the S&P/TSX Composite Index lost 37.2 per cent. On the other side of the coin, the small cap index has also recovered faster, posting total returns of 96.2 per cent from the bottom of the market to Tuesday’s close (in comparison with 51.4 per cent for the S&P/TSX Composite on the same basis). Although not for the faint of heart, looking for lesser-known companies can provide opportunity for significant gains. To this end, today I use Morningstar CPMS to look for potential buys by ranking the 483 companies in our Canadian database that are not in the S&P/TSX Composite on the following metrics:
- Quarterly earnings and cash flow momentum (compares the past four quarters of operating earnings and cash flow, respectively, with the same figure one quarter ago, higher figures preferred);
- Five-year average return on equity (a profitability metric, higher figures preferred);
- Five-year deviation of earnings (a statistical measure that describes how consistent earnings have been over the past 60 months, lower figures preferred).
To qualify, companies must not be listed as a constituent of the S&P/TSX Composite. Additionally, only companies that have an average daily trading volume (measured over the past three months) valued at $200,000 or more were included (this figure represents the median value of the universe).
More about Morningstar
Morningstar Research Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. Morningstar offers an extensive line of products and services for individual investors, financial advisers, asset managers, retirement plan providers and sponsors, and institutional investors. Morningstar Direct is the firm’s multi-asset analysis platform built for asset management and financial services professionals. Morningstar Canada on Twitter: @MorningstarCDN.
What we found
I used Morningstar CPMS to back-test this strategy from June, 2002, through November, 2020, using a maximum of 15 stocks with no more than three for every economic sector. Once a month, stocks were sold if they fell below the top 25 per cent of the universe based on the above factors. Additionally, to account for the often less liquid nature of the names in the model, a 1-per-cent liquidity cost was included (implying that stocks were sold for 1 per cent less than the close price on the last trading day of the month, and bought for 1 per cent more). Over this time frame and on this basis, the strategy produced a total return of 12.2 per cent, while the S&P/TSX SmallCap Index advanced 4 per cent. Only 12 stocks met the requirements to be purchased into the model today and are listed in the accompanying table.
This article does not constitute financial advice. It is always recommended to speak with a registered investment adviser or professional before investing.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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