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A portfolio of Canadian stocks that focuses on downside protection

What are we looking for?

Quality Canadian stocks for the investor focused on capital preservation.

The screen

In times of market uncertainty, I often like to remind myself of famed investor Warren Buffett's first two rules of investing. Rule No. 1: Don't lose money. Rule No. 2: Don't forget Rule No. 1.

It can be easy to get bogged down by short-term portfolio performance. Everybody wants to see their portfolio making money, no matter what type of investor you are. But reward and risk come hand in hand. While it may seem like the only way to win is to make money, I believe Mr. Buffett's words hold true and that you can also achieve a victory by not losing.

Today, I'm showcasing a strategy that focuses entirely on selecting stocks based on protecting on the downside. My belief is that this approach will help reduce some of the sting when markets tumble while still uncovering stocks that maintain slow and steady growth. The hope is that this will result in a portfolio that outperforms the market across the long term. This strategy ranks stocks using the following factors:

  • Variability of historical earnings per share (a metric that calculates how stable a company’s earnings are over its full history – a low value is best);
  • Five-year beta (measures a company’s sensitivity relative to changes in the benchmark – in this case the S&P/TSX composite. For example, in trending markets, a stock with beta of less than one has historically moved less than the index).
  • Five-year standard deviation (measures the variability of total returns; a low value is best);
  • Free-cash-flow-to-debt ratio (used to ensure companies are not holding too much debt relative to available cash; a high value is best). Note the presence in the table of “not calculable” (n/c) for several companies in this column; this occurs when the ratio’s denominator – long-term debt – is equal to zero, so the ratio is not able to be calculated.

In order to qualify, stocks must be in the top 25 per cent of the universe and have earnings variability and five-year standard deviation in the bottom two thirds of peers (today these values must be less than 13.43 and 29.99 per cent, respectively). Stocks must also have five-year beta less than one and a free-cash-flow-to-debt ratio greater than 1.1.

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 September, 2004, to July, 2017. During this process, a maximum of 10 stocks were purchased. Stocks were sold if their rank fell below the top 40 per cent of the universe, if the company's five-year beta rose above 1.3, or if the company's free-cash-flow-to-debt ratio fell below one. 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 15 per cent while the S&P/TSX composite total return index advanced 7.4 per cent across the same period. Stocks that qualify for purchase into the strategy today are listed in the table.

Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.

Emily Halverson-Duncan is an account manager for CPMS at Morningstar Research Inc.

Select Canadian stocks for the long-term investor

RankCompanySymbolMarket Cap. ($ Mil.) Earnings Variability 5Y Beta5Y Stand. Deviation (%)Free Cash Flow/DebtDividend Yield (%)
1Toronto-Dominion BankTD-T117,738.103.80.712.91.23.8
2Richelieu Hardware Ltd.RCH-T1,829.102.40.520.4246.80.7
3A&W Rev. Royalties IFAW.UN-T402.23.90.916.3n/c4.8
4Corby Spirit & Wine LtdCSW.A-T618.36.50.516.5n/c3.9
5Calian Group Ltd.CGY-T205.95.50.618.4n/c4.2
6Descartes SystemsDSG-T2,568.509.2-0.123.5n/c0
7Sun Life Financial Inc.SLF-T29,714.606.60.519.41.53.6
8BMTC Group Inc.GBT-T442.25.80.523.7n/c2
9Evertz TechnologiesET-T1,354.309.10.223.228.74
10Winpak Ltd.WPK-T3,412.508.40.523.9n/c0.2

Source: Morningstar Canada

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