What are we looking for?
Stocks in the S&P 500 that display earnings and profitability growth.
The screen
Volatility on the S&P 500 has reached new lows for the year and post-Brexit gains have pushed the index to an all-time high.
However, even though there has been an upward trend in the index for the quarter so far, we saw quick changes of direction in just a matter of weeks earlier this year. Bullish investor sentiment in the U.S. has dropped in the past few weeks and remains below historical averages. Nevertheless, when considering equities in the U.S. market, investors can still find stocks with a positive outlook for growth.
Today, I use Morningstar CPMS to look for stocks that exhibit forward earnings and profitability growth.
Our criteria included:
- Earnings growth for the current year (the difference between the median earnings per share estimate for the current year versus the company’s EPS for the previous year).
- Earnings growth for next year (the difference between the median EPS estimate for next year versus the median EPS estimate for the current year).
- Forward return on equity (a profitability metric that divides the current consensus EPS by the adjusted book value of equity).
Stocks are only purchased in the strategy if they have positive estimated earnings growth and forward return on equity. Stocks must also have a long-term debt to equity ratio of 0.5 or less and have cash flow to debt of 0.4 or greater to ensure they are not overly leveraged.
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 April, 2004, to July, 2016. During this process, a maximum of 15 stocks in the S&P 500 were purchased and equally weighted with a maximum of five stocks a sector. Stocks would be sold if they fell below minus 10-per-cent earnings growth for the current year or forward return on equity fell below minus 10 per cent. Stocks would also be sold if their debt to equity rose above 0.9 or cash flow to debt ratio fell below 0.2. The portfolio is rebalanced monthly. Over this period, the strategy produced an annualized total return of 14.2 per cent while the S&P 500 total return index advanced 7.9 per cent. Today, 15 stocks qualify for purchase into the strategy and 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.
Michael Pe, CFA, is an institutional product specialist for CPMS at Morningstar Research Inc.