What are we looking for?
Recently, we used Morningstar CPMS to look for Canadian companies that have really good revenue and have been able to translate that into better earnings growth. Today, we repeat the exercise – this time for U.S.-listed names.
The screen
With so much uncertainty coming from geopolitical risk, unexpectedly high inflation and rising interest rates, some investors fear a recession may be around the corner. During the current market volatility, it can be even more important to focus on corporate fundamentals. Revenue growth, for example, can eventually lead to higher bottom-line growth if expenses have been managed properly. We also want companies that have their debt levels under control because higher interest rates can create more liquidity and solvency risks.
CPMS will adjust earnings per share in order to remove non-recurring items that can lead to misguided conclusions. For example, in calculating annual earnings momentum in today’s screen, CPMS adjusted Pioneer Natural Resources Co. earnings upward by about 84 per cent after removing items such as gains from derivatives and losses from the disposal of assets. Eliminating these non-essential items makes it easier to compare net income between different companies and throughout different time periods.
Furthermore, we screened for return on equity, an important factor to assess financial performance; ROE can be broken down into other key company metrics, including net profit margin, return on assets and leverage.
We used two different momentum factors to take advantage of stocks that are trending in the right direction. Stocks trading near their 12-month high have tended to continue to perform well, and we 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 60, for example, has performed better than 60 per cent of the other companies in our database over that period.)
Lastly, we used the Morningstar Quantitative Financial Health Score, which is a proprietary factor that measures the probability that a firm will fall into financial distress. It uses a predictive model designed to anticipate when a company may default on its financial obligations. The average score of all companies in our database is 0.62; a perfect (or most financially healthy) score would be 1.0.
The investment process started off with all 2,015 American stocks in our CPMS database. Then we ranked our stocks according to the market capitalization, annual sales momentum and earnings momentum (that is, the percentage change in latest four quarters versus one year ago), and the price relative to the three-month average for the CPMS database.
Next, we applied five screens to create our list of stocks:
- Market capitalization above US$1.8-billion;
- Forward return on equity above 20 per cent;
- Price decline of less than 20 per cent from the stock’s 12-month high;
- Morningstar Quantitative Financial Health Score of 0.62 or higher;
- Price relative to three-month average greater than 50.
What we found
We used CPMS to back-test the strategy from January, 2006, to January, 2021. 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 an annualized total return of 15.4 per cent since inception whereas the S&P 500 Total Return Index rose 10.2 per cent on the same basis. 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.
Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
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Phil Dabo, MFin