What are we looking for?
Value-oriented stocks within the U.S. small-cap universe.
The screen
Value investing has been practised for many years. Famed investors such as Benjamin Graham, Peter Lynch and Warren Buffett have shown us how profitable value strategies can be. This investment style continues to be implemented by a number of portfolio managers and is available across many different investment vehicles. With so many options, it can be overwhelming for investors to find a successful value strategy that differentiates from the norm.
What I've done today is create a value strategy that ignores the well-known, blue-chip companies many investors are accustomed to seeing in their portfolio. Instead, this strategy focuses solely on small-cap stocks that tend to have a smaller number of analysts following them. This strategy ranks stocks using the following factors:
- Price to trailing earnings (measured as the company’s most recent share price divided by the previous four quarters’ earnings per share);
- Free cash flow (a profitability metric).
In order to qualify, stocks must have a market cap below $5.8-billion (U.S.) and trailing P/E below 21.6 (these figures represent the bottom two-thirds of all U.S. stocks).
In order to ensure companies are not overly leveraged, they must have a debt-to-equity ratio of no more than 1.1. Lastly, stocks must have free cash flow in the top one-third of peers.
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 April, 2004, to June, 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 debt-to-equity ratio grew to more than 1.3; or if the company's free cash flow dropped below the bottom one-third of peers. 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 16.5 per cent while the benchmark (Russell 2000 index) returned 7.3 per cent across the same period. 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.
Emily Halverson-Duncan is an account manager for CPMS at Morningstar Research Inc.