What are we looking for?
Members of the S&P/TSX composite index that are growing earnings without being overly leveraged.
The screen
Last week, the Bank of Canada surprised analysts by raising the key interest rate for the second time in less than two months. For investors that believe this to be a signal for continued growth in Canada, this week's strategy may offer some ideas. To develop this strategy, I used Morningstar CPMS to rank the stocks in the S&P/TSX composite index based on the following factors:
Five-year earnings-per-share growth rate (on average, how much a company has grown its earnings annually over the past five years);
- Average return on equity over the trailing three and five years;
- Quarterly earnings momentum (latest four quarters of earnings compared with the same figure one quarter ago);
- Next quarter’s earnings momentum (latest three quarters of reported earnings plus the median estimate for next quarter’s EPS, compared with the trailing four quarters of EPS);
- Three-month estimate revision (today’s consensus estimate for EPS compared with the same figure at month-end three months ago).
Only companies in the S&P/TSX composite index were considered in this analysis. Additionally, stocks that have a debt-to-equity ratio higher than that of the sector median were excluded to avoid overly leveraged companies (a figure of 0.4, for example, implies that the stock has a D/E ratio 60 per cent lower than that of the sector to which it belongs).
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 December, 1991, to August, 2017. During this process, a maximum of 20 stocks were purchased with a maximum of four per economic sector to ensure reasonable diversification. Stocks were sold if their rank fell below the top 35 per cent of the universe, or if a company reported negative earnings. 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 15.7 per cent while the S&P/TSX composite total return index gained an annualized 8.4 per cent. The top 20 stocks that meet our requirements for purchase are listed in the accompanying table.
As always, it is recommended that investors conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.