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What are we looking for?
Quality.
The screen
Today, I used Morningstar CPMS to construct a concentrated equity portfolio with one sole focus: quality. In the equity markets, quality can be defined in many different ways, but for today I ranked stocks using a combination of the following metrics:
- Market cap (here, we prefer larger companies with good liquidity as a safety factor);
- Earnings variability (a proprietary CPMS measure looking at how consistent a company’s reported earnings have been over a long history – lower scores preferred);
- Three-year and five-year beta (recall that beta measures a stock’s historical sensitivity to a benchmark. In trending markets, a stock with beta less than one has historically moved less than the index);
- Debt-to-equity ratio (here, we prefer companies that are less leveraged).
To qualify, stocks must be well ranked based on the above factors, but must also have a debt-to-equity ratio that is equal to or lower than the median of the sector to which it belongs. Additionally, qualifying stocks must have a positive current year earnings-per-share estimate, a positive trailing EPS and a neutral or positive earnings surprise in the latest reported quarter. Only companies in the S&P/TSX composite index were included in this analysis.
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, 1998, to March, 2017. During this process, a maximum of 10 stocks were purchased with a maximum of one per economic sector to ensure reasonable diversification. Stocks are sold if their rank falls below the top 40 per cent of the universe, or if earnings (trailing or estimated) turn negative, or if the company missed EPS expectations in a given quarter by more than 5 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 11.7 per cent while the S&P/TSX total return index advanced 6.3 per cent. In calendar year 2008, this strategy showed losses of 20 per cent while the S&P/TSX total return index lost 33 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.
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