What are we looking for?
Profitable companies not covered extensively by institutional analysts.
The screen
As we trudge through the rest of earnings season in Canada, many investors are likely paying especially close attention to analyst expectations and whether stock reports beat or miss said expectations (which often drive a stock price immediately after earnings are released). However, in Canada, there are several companies that are either too small to be considered by institutional analysts, or too illiquid to be owned by large institutional investors. This week, I look for companies in this space, specifically focusing on companies that have fewer than two active analysts covering the stock (today, this list consists of 308 companies in the CPMS Canadian database). Among these companies, I ranked stocks based on:
- Price change from month-end three, six and nine months ago (here, higher values are preferred to find companies moving in the upward direction);
- Latest reported return on equity;
- Average return on equity over the last three years;
- Five-year earnings-per-share growth rate (on average, how much earnings have grown each year in the last five years);
- Quarterly earnings momentum (past four quarters of earnings compared with the same figure one quarter ago);
To qualify, companies must have an average monthly trading volume of at least 700,000 shares (this figure represents the bottom one-third of stocks in our universe).
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 110 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, 2004, to May, 2018. During this process, a maximum of 10 stocks were purchased and equally weighted with no more than three per economic sector. Once a month, stocks were sold if their rank fell below the top half of the ranked universe, or if the trailing four quarters of earnings turned negative. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Because the relative illiquidity of these stocks could affect trading prices, a liquidity cost of 1 per cent was included in this analysis (stocks were purchased at 1-per-cent higher than their close price, and sold at 1-per-cent lower). Over this period, the strategy produced an annualized total return of 14.9 per cent while the BMO Nesbitt Burns Canadian Small Cap Total Return Index gained 5.3 per cent.
The stocks that meet our requirements for purchase (none of which pay a dividend) are listed in the accompanying table.
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.