What are we looking for?
Canadian stocks selected with a focus on earnings.
The screen
With earnings season right around the corner, many investors will be closely watching to see how the reports look for the companies they hold. Earnings can have a significant effect on the price of a stock, especially in the short term. If a company were to severely miss analyst expectations, this can be seen as a very negative signal and cause a sell-off as investors react to the news – or vice versa if the stock were to significantly beat expectations.
One way to capitalize on this season is to look for companies with a strong history of both growth and surpassed expectations related to earnings, coupled with a risk-reduction metric such as variability of earnings (defined below) to help avoid companies with massive swings in profitability.
Today’s strategy uses historical earnings-focused factors to look for stocks within the CPMS Canadian universe – currently, this universe holds 709 names. In order to qualify, stocks must have:
- A market capitalization in the top two-thirds of peers (today, this value is $114.3-million or higher);
- Positive quarterly earnings momentum (measured as the growth in the trailing four quarters of earnings compared with the trailing four quarters of earnings lagged by one quarter, higher values preferred);
- Positive quarterly earnings surprise (proprietary measure of the difference between actual and expected quarterly earnings, higher values preferred);
- Five-year beta relative to the S&P/TSX Composite Index of less than or equal to one (as a measure of a company’s sensitivity relative to changes in the benchmark, a value of less than one would indicate the stock is less volatile than the market, lower values preferred);
- Variability of historical earnings per share that is in the top two-thirds of peers (today, this translates to a value of 19.8 per cent or lower – this measures the volatility of a company’s reported EPS).
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.
What we found
I used Morningstar CPMS to back-test this strategy from May, 1992, to August, 2019. During this process, a maximum of 15 stocks were purchased. Stocks were sold if the company’s five-year beta rose above 1.1, or if either the quarterly earnings momentum or quarterly earnings surprise fell below minus 8 per cent. 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 16.1 per cent while the S&P/TSX Composite Index registered a total return of 8.6 per cent over the same period. One thing worth noting is that this model outperformed the benchmark in 77 per cent of down markets (measured as a quarter where the benchmark had negative returns). 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, CFA, is a director, CPMS sales at Morningstar Research Inc.
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Emily Halverson-Duncan, CFA