Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
What are we looking for?
Companies that have reported strong earnings.
The screen
A total of 437 companies on the S&P 500 index have reported earnings since the beginning of July, with 75 per cent of them beating analysts’ expectations. This is very important because there has been a lot of uncertainty surrounding the U.S. economy, with high inflation, negative real GDP growth and rising interest rates.
Many investors were keeping a close eye on second-quarter earnings to see if there would be an indication the U.S. economy was in a recession. However, corporate earnings have been strong, with 65 per cent of companies recently reporting positive quarterly earnings compared with 65 per cent of companies reporting negative quarterly earnings growth during the 2020 recession.
Today, I used Morningstar CPMS to look for American companies of all sizes that have recently beat analysts’ expectations for earnings per share. CPMS uses a proprietary methodology to calculate the quarterly earnings surprise. It is adjusted in two ways: A decay factor is used to reduce the surprise as time passes. Earnings variability is also factored into the calculation to ensure that if two companies beat the consensus estimate by the same percentage, the company with the lower earnings variability will have the higher earnings surprise.
I also used another proprietary variable to determine if a company is in good financial health. The Morningstar Quantitative Financial Health Score was used to make sure companies are in a good financial position with a low probability of financial distress. It’s also important to capture companies that are performing relatively better than the market, so I used the three-month relative strength of the stock price to find those outperformers.
The investment process started off with all 2,000 U.S. stocks in our CPMS database. Then we ranked our stocks from 1 to 2,000 according to the quarterly earnings surprise, quarterly earnings momentum, three-month earnings revision, variability around five-year earnings per share, quarterly sales momentum, and the three-month relative strength in price compared to our database of stocks.
Next, we applied four screens to create our list of stocks:
- three-month earnings revision greater than 3 per cent
- 180-day standard deviation less than 45 per cent
- Morningstar Quantitative Financial Health Score above 0.6
- quarterly sales momentum above 1.5
What we found
I used CPMS to back-test the strategy from January, 2006, to July, 2022. During this process, a maximum of 15 stocks were purchased and weighted according to their rank. The portfolio is rebalanced monthly and the strategy produced a return of 15.1 per cent since inception, whereas the S&P 500 Total Return Index returned 9.5 per cent.
Today, the top 15 stocks that qualify for purchase into the strategy 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.
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