Quality matters for both large and small stocks, but it is particularly important when dealing with smaller stocks.Tijana Martin/The Canadian Press
Visiting farmers’ markets is a summer joy because the best of them offer premium produce at fair prices.
Investors can shop in a similar manner in the stock market where they might be able to buy wonderful companies at fair prices.
Today the search is on for the best measures of quality for both large and small Canadian stocks. It turns out that quality matters for both but it is particularly important when dealing with smaller stocks.
When it comes to size, large stocks are defined herein as being the 100 largest on the Toronto Stock Exchange based on market capitalization. On the other hand, small stocks are the next 200 largest stocks.
A portfolio composed of the 100 largest stocks gained an average of 9.3 per cent annually over the 25 years to the end of 2024 while the 200 smaller stocks gained an average of 8.6 per cent annually. In comparison, the S&P/TSX Composite Index chalked up average annual returns of 7.2 per cent over the same period. (The returns herein are based on backtests using data from Bloomberg over the 25 years to the end of 2024. They include dividend reinvestment but not fund fees, taxes, commissions or other trading costs. All of the portfolios are equally weighted and rebalanced at the end of each year.)
With the returns of the large and small stock portfolios in hand, it’s time to delve into the market’s data mine to see which measures of quality performed the best over the past quarter century.
Longevity is a simple test and it provided a modest lift. A portfolio containing large stocks with at least five years of trading history on the TSX grew at an average annual rate of 9.9 per cent over the 25 years while similarly-old small stocks grew by 9.4 per cent annually.
Seeking stocks with positive earnings, or cash flow from operations, was also beneficial. Large stocks with positive earnings gained an average of 9.7 per cent annually while similar small stocks climbed 10.9 per cent. Large stocks with positive cash flows advanced 10.2 per cent annually while cash-flow positive small stocks jumped by 10.6 per cent.
The remaining tests narrow the portfolios of large, and small, stocks down to the 20 per cent of stocks with the highest, or lowest, measures of quality.
For instance, the 20 per cent of stocks with the lowest volatilities (over the prior 260 days) outperformed nicely. The portfolio of 20 low-volatility large stocks enjoyed an annualized growth rate of 10.7 per cent over the 25-year period while the portfolio of 40 low-volatility small stocks grew by 13.2 per cent annually. As it happens, low volatility was the top-performing quality factor for small stocks where it also yielded the best overall returns.
Looking for high return-on-equity (ROE), high return-on-invested-capital (ROIC), or high return-on-assets (ROA) was a good idea when applied to small stocks owing to their average annual gains of 11.5 per cent, 11.1 per cent, and 9.8 per cent, respectively. However, high ROIC was the only outperformer of the three when it came to large stocks with an average annual advance of 10.1 per cent.
Portfolios with high gross-profits-to-asset ratios (GP/A) also fared well, with high GP/A large stocks jumping 12.4 per cent annually while their smaller sisters gained 10.6 per cent. High GP/A was the top performing factor for large stocks but it excluded banks and other financials.
Stocks with high cash-flow-to-earnings ratios (CF/E) also provided a nice lift with gains of 11.5 per cent annually when applied to large stocks and 12.3 per cent when applied to small stocks.
Leverage offers a potentially counterintuitive example because high-leverage large-stocks outperformed with gains of 11.9 per cent annually while similar small stocks gained 12.3 per cent. High leverage proved to be the second-best quality factor for both large and small stocks. The results likely reflect the ability of healthy companies to borrow money. As an aside, low-leverage companies (the sort that banks might be reluctant to lend to) underperformed with low-leverage large stocks climbing 6.5 per cent annually and similar small stocks gaining just 1.9 per cent.
Overall, the quality factors provided an average annual performance boost for large stocks of about 1.1 percentage points and about 2.6 percentage points when applied to small stocks.
Think about quality on your next trip to the market because you might be able to pick up a few wonderful – or pretty good – companies at reasonable prices.
Updates for the portfolios I follow for The Globe and Mail can be found via this link.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
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