What are we looking for?
Canadian stocks with an economic "moat” that are on a growth trajectory.
The screen
With a gangbuster year in Canadian equities behind us, investors who feel that the trajectory of growth in domestic markets will continue can look to today’s model for some ideas. To find these companies, I used Morningstar CPMS to rank companies on the following metrics:
- Reported return on equity and return on capital;
- Five-year normalized growth rate of earnings per share (on average, how much earnings have grown each year over the past five years);
- Five-year EPS deviation (the variability of reported earnings, lower figures preferred).
To qualify, companies must be given a “wide” or “narrow” economic moat rating from Morningstar’s research analysts.
Morningstar’s economic moat ratings centre around a company’s ability to earn a return on capital higher than its cost of capital over the medium to long term. Morningstar’s analysts see five distinct sources of economic moat: network effect (when the value of a company’s service increases for new and existing users as more people use the service); intangible assets (such as patents, brands, regulatory licences); cost advantage (for example, being able to undercut competitors on price while earning similar margins); switching costs (when it would be too troublesome to stop using a company’s products); and efficient scale (when a niche market is effectively served by one or a small handful of companies).
A company whose competitive advantages we expect to last more than 20 years has a wide moat, while one that can fend off their rivals for 10 years has a narrow moat. A firm with no advantage has no moat.
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 April, 2012, to the end of December, 2019 (note it was April, 2012, that Morningstar’s economic moat ratings first appeared in the CPMS Canadian database). During this process, a maximum of 15 stocks were purchased and equally weighted with no more than four stocks per sector. Once a month, stocks were sold if their rank fell below the top 35 per cent of the universe, or if Street consensus estimates fell by more than 10 per cent.
Over this period, the strategy produced an annualized total return of 15.2 per cent while S&P/TSX Composite Index gained 7.6 per cent on the same basis. In calendar year 2018, the strategy lost 0.3 per cent while the index lost 8.9 per cent.
The stocks that qualify for purchase are listed in the accompanying table. It is always recommended to speak to a financial adviser or investment professional before investing.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.
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Ian Tam, CFA