What are we looking for?
Small-cap U.S. stocks with earnings momentum.
The screen
Companies that are smaller come with a lot of investment risks, such as illiquidity, and they can also present more analytical challenges if their earnings are less transparent owing to management bias. Smaller companies may have lower quality financial statements because of weaker internal controls to catch accounting misstatements.
CPMS uses a proprietary methodology to remove common accounting items (such as one-time restructuring charges, gains on buybacks and litigation charges) that do not accurately reflect a company’s operating earnings. By making earnings per share more transparent, it makes it easier to take advantage of some of the benefits of small-cap stocks, such as generating excess returns compared with the S&P 500 and diversifying your portfolio if it is heavily tilted toward large cap stocks.
An additional benefit of investing in small U.S. companies is the ability to shield your portfolio from global economic risks because a lot of them are focused on the domestic market.
Today, we use Morningstar CPMS to look for smaller companies that are expected to increase their earnings next quarter and have recently beaten analyst expectations for earnings per share.
Earnings momentum next quarter compares the three quarters of trailing operating earnings per share – plus the estimated EPS for next quarter – with the four quarters of trailing operating EPS.
We also want companies with earnings per share that analysts have been revising upward and have recently beaten analyst expectations for their recent quarterly earnings. Trailing return on equity, or ROE, is a very good metric that measures financial performance, and price-to-sales can help us identify companies that are trading at a discount to the amount of sales generated. (The S&P 500 price-to-sales ratio is 3.4.) Price change from 12-month high is here because we’ve found that stocks that are trading close to their most recent high have continued to perform well.
Lastly, we used the market price relative to the 80-day moving average. This is another momentum indicator. I have found that when the market price falls below the 80-day moving average by 5 per cent or more, the market continues to sell off.
The investment process started off with all 2,013 stocks in our U.S. database. Then we ranked our stocks, according to the earnings momentum next quarter, three-month analyst revision, quarterly earnings surprise, trailing ROE and price-to-sales.
Next, we applied these screens to create our list of stocks:
- Market capitalization below US$1.8-billion;
- Three-month earnings revision above zero;
- Price decline from 12-month high less than 16 per cent;
- Trailing ROE above 20 per cent.
In addition, the current market price (the S&P 500, this is not stock-specific) must not be more than 5 per cent below its 80-day average. As the table indicates, the market price as of last market close is 0.6 per cent higher than its 80-day moving average.
What we found
I used CPMS to back-test the strategy from January, 2006, to February, 2022. During this process, a maximum of 10 stocks were purchased and equally weighted. The portfolio is rebalanced monthly and the strategy produced a total return of 23.9 per cent since inception whereas the S&P/TSX Total Return Index gained 10.2 per cent. Today, the top 10 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