What are we looking for?
Growth and profitability in the S&P/TSX composite index, while keeping an eye on valuations.
The screen
This week, I look at a GARP-like strategy that looks at stocks with good profits over the past number of years and that are trading within range of their historical median valuations (GARP stands for growth at a reasonable price). The strategy ranks stocks based on the following factors:
- Forward price-earnings to growth (PEG) ratio – calculated here by dividing the forward price-to-earnings ratio by the forward reinvestment rate. GARP investors look for companies with low PEG ratios to ensure they’re not overpaying per unit of reinvestment;
- Five-year earnings-per-share growth rate;
- Annual earnings momentum (the latest four quarters of reported earnings, compared against the same figure four quarters ago);
- Three-year, five-year and 10-year average trailing return on equity.
To qualify, stocks must be part of the S&P/TSX composite, and must be trading at less than 1.1 times their historical median price to earnings, price-to-sales and price-to-cash-flow ratios.
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 CPMS to back-test the strategy from January, 1999, to September, 2016. During this process, a maximum of 10 stocks were purchased and equally weighted with a maximum of three stock per sector. Stocks would be sold if they fell outside the top 30 per cent of the ranked universe, or if any of the historical relative valuation metrics mentioned above breached 1.3 times.
Over this period, the strategy produced an annualized total return of 11.4 per cent while the S&P/TSX composite total return index advanced 7.1 per cent. The top 10 stocks that qualify for purchase 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.