What are we looking for?
Companies that have beaten earnings expectations with recent low volatility in total return.
The screen
With the second-quarter reporting season out of the way, savvy investors are likely paying attention to companies that have surpassed analysts' expectations. These companies often show positive price returns after reporting dates, reflecting unexpected market information that rapidly gets priced into a stock's value. That said, looking at just earnings surprise is often a roller-coaster ride ripe with volatility as companies who beat estimates one quarter can just as easily miss estimates in the next. To balance out this volatility, this week I used Morningstar CPMS to create a model that ranks stocks on the following factors:
- Latest earnings surprise (which compares the company’s latest reported quarter of earnings against the consensus estimate just prior to the company’s report – positive and higher figures preferred);
- Standard deviation of total returns over the trailing six and 12 months (standard deviation is a measure of volatility, lower figures preferred. The idea here is to penalize companies that have higher volatility in their return history, inclusive of dividends).
Only companies with a market cap of $700-million were included in this analysis (this figure represents the median market cap in the Morningstar CPMS database, which today consists of 700 companies).
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 January, 1999, to July, 2017. During this process, a maximum of 20 stocks were purchased with a limit of four per economic sector to ensure reasonable diversification. Stocks are sold if their rank falls below the top 35 per cent of the universe, or if the company missed earnings expectations. 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 12.9 per cent while the S&P/TSX composite total return index gained 7 per cent. Stocks that qualify for purchase into the strategy today 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.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.