What are we looking for?
Canadian-listed companies in a good financial position.
The screen
After a period of extraordinary growth, the economy is in the midst of slowing down, making it even more difficult to predict where it will be over the next year, especially with the Bank of Canada’s significant interest-rate hikes to battle high inflation.
Today we use Morningstar CPMS to look for Canadian companies able to withstand higher rates. The Morningstar Quantitative Financial Health Score will help us find companies that appear financially strong. This is a proprietary variable that measures the probability that a firm will fall into financial distress. It uses a predictive model designed to anticipate when a company will default on its financial obligations. We use the reinvestment rate to find companies that are growing organically by reinvesting in their business. We also want to find companies with a strong return on equity, which is a good measure of a business’s financial performance. Lastly, we used the 180-day standard deviation (a statistical measure of how much the price moves in relation to its mean or average value) to reduce the amount of price risk in the portfolio.
The investment process started off with all 700 companies in our Canadian CPMS database. Then we ranked our stocks from one to 700 according to the Morningstar Quantitative Financial Health Score, reinvestment rate, return on equity and 180-day standard deviation.
Next, we applied four screens to create our list:
- Morningstar Quantitative Financial Health Score ranked in the top third of our list, or greater than 0.65 (A perfect score is 1.0);
- Reinvestment rate in the top third of our list, which is or 7.6 per cent or higher;
- Return on equity above 10 per cent;
- 180-day standard deviation in the top half of results, which is less than 50 standard deviations away from the mean or average.
What we found
I used CPMS to back-test the strategy from January, 2006, to August, 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 annualized return of 16.1 per cent since inception whereas the S&P/TSX Total Return Index generated 6 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.