What are we looking for?
U.S.-listed growth companies that don't appear overvalued relative to their respective sectors.
The screen
An increasing concern for many investors is the continued buildup of the U.S. market. Year to date, the S&P 500 total return index is up about 9.6 per cent, continuing a rally that essentially spans back to 2009. Further concern is validated when looking at the price-to-book ratio for the index, which currently sits at roughly three, a level close to that of September, 2007, prior to the 2008 housing bubble. By no means does this imply we are heading into another 2008, but it does raise the question whether there is still room left for value investors.
This said, today's strategy focuses on growth companies that don't appear overvalued in relation to their sectors, as a way for investors to take advantage of continued optimism in the U.S. economy while avoiding paying a large premium. The strategy ranks stocks on the best combination of:
• Earnings deviation (a volatility measure showing how consistent a company's reported earnings per share have been over the past five years – lower figures preferred);
• Three-year and five-year growth rate of earnings.
To qualify, companies must have valuations ratios (price-to-earnings, price-to-book, price-to-cash-flow, price-to-sales) within range of their sector medians (in the table, an industry relative P/E ratio of 0.8, for example, implies that the company's P/E is 20 per cent lower than that of the sector median). Additionally, companies must show positive earnings in their most recent report and a debt-to-equity ratio lower than that of the sector median to avoid overly leveraged 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 April, 2004, to May, 2017. During this process, a maximum of 15 stocks were purchased with a maximum of four an 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's earnings turn negative. 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 12.7 per cent while the S&P 500 total return index advanced 8.4 per cent. Today, only 13 stocks qualify for purchase into the strategy and they 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.