What are we looking for?
Canadian companies with a sustainable competitive advantage.
There has been a lot of uncertainty in the financial markets over the past month, with the CBOE Volatility Index peaking on Dec. 1 at its highest level since January, much of that related to the rise of the COVID-19 variant Omicron.
Many investors are looking for safer investments that will provide stability in case the economy goes through a period of lower economic growth.
Companies that have a sustainable competitive advantage should be able to provide more consistent investment returns because they’re able to produce goods and services more efficiently than competitors, which leads to greater profit margins. The Morningstar Economic Moat Score is based on the likelihood that companies can keep competitors at bay for an extended period of time.
Today, I use Morningstar CPMS to look for Canadian companies of all sizes that have a sustainable competitive advantage. The Morningstar Economic Moat variable uses a proprietary methodology to assess whether a company is exposed to a substantial threat of value destruction stemming from risks such as industry disruption or financial health. These are factors that would reduce the firm’s economic profit and prevent it from consistently achieving above-benchmark returns over long periods. Not only is it important for companies to have strong earnings, but it is also important for them to be able to turn that profitability into cash.
I used two different factors to find companies with strong cash flow momentum. The first is based on the actual cash flow from the most recent quarter, and the second is based on the median analyst estimate for cash flow in the next quarterly financial report. Lastly, I used the price change from the 12-month high because stocks that trade near their 52-week high have continued to perform well on a historical basis.
The investment process started off with all 700 Canadian companies in our CPMS database. Then we ranked our stocks according to the Morningstar Economic Moat, quarterly cash flow momentum (the latest four quarters of reported cash flow from operations per share compared with the same figure from one quarter ago), and the median of estimate revisions that have occurred over the past 60 days for next quarter’s cash flow.
Next, we applied six screens to create our list:
- Morningstar Economic Moat score of three or more (zero represents no moat, whereas five represents a wide moat);
- Market cap above $1.5-billion;
- 60-day estimate revision for next quarters cash flow that is positive;
- Quarterly cash flow momentum that is positive;
- A price decline from 12-month high that is less than 15.5 per cent;
- A one-month price change that is positive, or if negative, has declined less than 5 per cent.
What we found
I used CPMS to back-test the strategy from January, 2012, to November, 2021. During this process, a maximum of 10 stocks were purchased and equally weighted. The portfolio is rebalanced monthly and the strategy produced a return of 14.5 per cent since inception, whereas the S&P/TSX Total Return Index advanced 8.5 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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