What are we looking for?
Low-volatility U.S. stocks with good cash flow.
The screen
Amid the COVID-19 pandemic, investors have seen a lot of fluctuations in their investment portfolios. While this can be difficult to stomach, there is a lot of evidence to support staying invested in the market over the long term. However, with the uncertainty surrounding how long social distancing, business closings and other coronavirus-related measures may last, now may be a good time to ensure your portfolio is adequately set up to withstand future market volatility.
Today’s strategy is searching for stocks poised to do well in down markets within the CPMS U.S. universe, which today consists of 2,093 companies.
This strategy ranks stocks based on five-year beta, industry-relative earnings variability, total-return standard deviation over three years and five-year annualized cash flow growth, as outlined below:
Five-year beta measures a company’s sensitivity relative to historical changes in the benchmark – here we use the S&P 500; in trending markets, a stock with beta less than one has historically moved less than the index (lower values preferred).
Industry-relative earnings variability measures how volatile a company’s earnings are relative to its industry median, lower (more negative) values preferred.
Total-return standard deviation over three years measures volatility of daily returns over that period (lower values preferred).
Five-year annualized cash flow growth measures how companies are increasing their cash on hand over the long term (higher values preferred).
Stocks that qualify must have:
- Five-year beta less than or equal to 0.8 (to reduce market sensitivity);
- Industry-relative earnings variability in the top two-thirds of peers (this value today is 7.3 per cent or less);
- Five-year standard deviation of monthly return on equity (a measure of risk) in the top half of peers (today this value is 3.1 per cent or less);
- Market capitalization in the top half of peers (today this value is US$2.2-billion or greater);
- Long-term debt-to-equity (a measure of liquidity) less than or equal to 1.1 to ensure companies don’t have excessive debt on hand;
- Five-year cash flow growth greater than zero.
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.
What we found
I used Morningstar CPMS to back-test this strategy from January, 2005, to February, 2020. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their five-year beta rose above 1.2, if their long-term debt-to-equity ratio rose above 1.3, or if their five-year cash flow growth fell below minus 5 per cent. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 11.2 per cent while the S&P 500 index gained 8.5 per cent on the same basis.
One thing worth noting is the performance through 2008, a decidedly volatile year: The benchmark declined 37 per cent on a total return basis, while the strategy lost 16.6 per cent.
Stocks that qualify for purchase into the strategy today 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.
Emily Halverson-Duncan, CFA, is a director, CPMS sales at Morningstar Research Inc.
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Emily Halverson-Duncan, CFA