What are we looking for?
A way to augment your index fund.
The screen
If you are an index investor in the main market cap-weighted benchmark in Canada (the S&P/TSX Composite Index) at the end of this past calendar quarter, roughly 60 per cent of your holdings were invested in three of 11 economic sectors (financials 32 per cent, energy 16 per cent and materials 11 per cent).
Such is the nature of the Canadian equity markets – a stark contrast to our U.S. neighbours, where we see diversity among various economic sectors. That said, for investors looking to augment their domestic index exposure, today’s strategy seeks quality companies outside of the three aforementioned sectors. Of the 233 stocks currently in the index, 126 of them are not in these sectors. Using Morningstar CPMS, I ranked these 126 companies on the following metrics:
- The price-to-earnings ratio of the stock, relative to its own 10-year historical median (here a figure of 0.9 implies that the stock’s P/E is 10 per cent lower than the median over the past 10 years);
- Five-year growth rate in earnings per share (on average, how much the company’s bottom line is growing each year over the past five years);
- Five-year average return on equity;
- Five-year price beta (a measure of sensitivity, in this case to the S&P/TSX Composite Index. In trending markets, a beta less than one implies that the stock has moved less than the market, lower figures preferred).
To qualify to be purchased today, the company must have posted positive trailing four quarters of operating earnings and a positive return on equity (not shown).
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 120 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to back test this strategy from January, 1999, to September, 2019. During this process, a maximum of 15 stocks were purchased and equally weighted with no more than three per economic sector (excluding the three mentioned above). Once a month, stocks were sold if their rank fell below the top 35 per cent of the index, if EPS turned negative, or if ROE turned negative.
Over this period, the strategy produced an annualized total return of 9.3 per cent while the S&P/TSX Composite advanced 7.1 per cent. In the trailing 12-month period ended Sept. 30, the strategy produced 13.9 per cent while the index gained 7.1 per cent.
The 13 stocks that qualify for purchase today are listed in the table below. It is always recommended to speak to a financial adviser or investment professional before investing.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.
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