What are we looking for?
Companies that have reported strong earnings.
The screen
As we go through earnings season it can be useful to focus on companies that have relatively stronger quarterly financial reports. With about half of the U.S. names in our database reporting, we look for those that have shown strong top line growth, which translates into higher net income if the company is able to keep its costs relatively low. Earnings season is also a time for analysts to change their financial models and adjust their projections for the company’s future profitability.
Today I use Morningstar CPMS to look for U.S. companies of all sizes that have recently beat analyst expectations for earnings per share. CPMS uses a proprietary methodology for calculating the quarterly earnings surprise. It is adjusted in two ways:
- The decay factor: The initial earnings surprise would have been based on consensus analyst estimates for fiscal year earnings per share. But the surprise becomes less relevant – decays – as time passes, and our figures are adjusted to reflect this.
- Earnings variability: This adjustment is 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. In other words, we are awarding more points to companies that have more consistent earnings.
I also used another proprietary variable to determine whether a company is in good financial health. The Morningstar Quantitative Financial Health Score measures the probability a firm will fall into financial distress. It uses a predictive model designed to anticipate when a company may default on its financial obligations.
It’s also important to capture companies that are performing relatively well, so I used the three-month relative strength of the stock price to find companies that are outperforming the market. A company that has a three-month relative strength of 90, for example, has performed better than 90 per cent of the companies in our database over the past three months.
Standard deviation is used to measure of a stock’s price volatility; 180-day standard deviation calculates how much the price can be expected to move from its 180-day average. A higher standard deviation indicates that the price is more volatile and carrying more risk.
The investment process started off with all 2,000 U.S. stocks in our CPMS database. Then we ranked our stocks according to the quarterly earnings surprise, quarterly earnings momentum, three-month earnings revision, variability around five-year average earnings per share, quarterly sales momentum and the three-month relative strength.
Next, we applied four screens to create our list:
- Three-month earnings revision of more than 2 per cent;
- 180-day standard deviation below 35 per cent;
- Morningstar Quantitative Financial Health Score of 0.6 or higher (a perfect score would be 1.0);
- Quarterly sales momentum above 1.5.
What we found
I used CPMS to back-test the strategy from January, 2006, to January, 2021. During this process, a maximum of 15 stocks were selected and ranked, taking into account all our screening criteria. The portfolio is rebalanced monthly and the strategy produced a total return of 15.7 per cent since inception whereas the S&P 500 Total Return Index returned 10.4 per cent. Today, the 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 buying any of the investments listed here.
Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
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