What are we looking for?
Financially healthy stocks on the Russell 1000 that have a sustainable competitive advantage.
Morningstar Inc. defines a “wide moat” company as one that has a sustainable competitive advantage that enables it to keep competitors at bay for an extended period. The idea is that all highly profitable companies attract competitors and firms that are able to keep rivals in check will earn superior profits for a long time. This is similar to the concept of an economic moat, popularized by Warren Buffett, where he refers to businesses with “economic castles protected by unbreachable ‘moats.’” These are companies that should be able to earn excess profits in perfectly competitive markets.
Today I use Morningstar CPMS to look for stocks that have wide moats, strong quarterly earnings momentum (a measure of profitability), strong quarterly cash flow momentum (an ability to consistently generate cash) and a high Morningstar Quantitative Financial Health Score (a proprietary measure indicating a company’s financial health based on the firm’s leverage). A higher score indicates lower leverage and less likelihood the company will fall into financial distress.
Companies that are financially stable with wide moats accompanied by strong quarterly cash flow and earnings momentum should be able to provide strong returns for investors over long periods.
The Russell 1000 was used to create this strategy because it provides a good mix of large and medium-sized companies.
First, we ranked our stocks in this index according to four key factors: economic moat, quantitative financial health, quarterly earnings momentum and quarterly cash flow momentum. (”Momentum” in this case is the percentage change between the latest four quarters of reported operating earnings/cash flow per share compared with the four quarters of operating earnings/cash flow from one quarter ago.)
Next we applied four screens:
- The highest wide moat score (out of five);
- Stocks with a market capitalization greater than US$3.8-billion;
- The highest Morningstar Quantitative Financial Health Score (out of three);
- A decline in the current price from the stock’s 12-month high of less than 5.4 per cent. (In theory, buying stocks that are trading near their previous 12-month high tend to continue doing well.)
What we found
I used CPMS to back-test the strategy from January, 2005, to November, 2020. During this process, a maximum of 10 stocks in the Russell 1000 were purchased and equally weighted. Stocks would be sold if their overall rank dropped out of the top 40th percentile of our list (that is, below the top 400 ranked stocks in our Russell 1000 universe). The portfolio is rebalanced monthly and the strategy produced an annualized total return of 16.9 per cent while the S&P 500 Total Return Index advanced 9.6 per cent. The top 10 stocks that qualify for purchase into the strategy 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.
Phil Dabo, MFin, is a director, CPMS sales at Morningstar Research Inc.
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