What are we looking for?
Overleveraged, overvalued stocks with shrinking earnings.
The screen
With April Fool’s Day just around the corner, I thought to highlight a number of Canadian-listed stocks that, for a combination of reasons, investors might want to double-check whether they still belong in their portfolios. Though not foolish investments, per se, these stocks exhibit a combination of fundamental characteristics that are generally unappealing to the conservative long-only investor. The stocks come from the Morningstar CPMS Canadian Dangerous strategy, which ranks stocks on:
- Debt-to-equity (higher figures preferred);
- cash flow to debt (lower figures preferred);
- latest earnings surprise (a surprise to the downside preferred);
- three-month earnings-per-share estimate revisions (negative or downward revisions preferred);
- sector-relative price-to-earnings and price-to-book ratios (in the table, a figure of 1.2 indicates that the stock’s multiple is 20 per cent higher than of the sector to which it belongs, higher figures preferred);
- quarterly earnings momentum (the latest four quarters of reported earnings compared against the same figure one quarter ago, lower or negative figures preferred).
Readers will quickly notice that the ranking order is counterintuitive. This is intended, as the strategy generally seeks companies that are overleveraged, overvalued, have shrinking earnings and have garnered negative sentiment from Street analysts.
More about Morningstar
Morningstar Research Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. Morningstar offers an extensive line of products and services for individual investors, financial advisers, asset managers, retirement plan providers and sponsors, and institutional investors. Morningstar Direct is the firm’s multi-asset analysis platform built for asset management and financial services professionals. Morningstar Canada on Twitter.
What we found
Morningstar CPMS has tracked the Dangerous strategy for more than three decades. The tracked portfolio holds a maximum of 30 stocks on an equally weighted basis with no sector limits. Over the long term, it performed as one might expect – poorly.
On a trailing 10-year basis, the strategy lost 12.5 per cent on an annualized basis while the S&P/TSX Composite Total Return Index gained 8.5 per cent annualized.
That said, the strategy doesn’t always perform poorly. In fact, there were several calendar years where the strategy outperformed the index by a great margin, namely in 1999 (pretech bubble), in 2009 (during the recovery period of the global financial crisis) and more recently in 2016. This might be because these years highlight periods of unjustified market exuberance for stocks that, on the surface, might look undervalued. For conservative investors looking for more reasonable returns consistently over time though, you likely won’t find those on today’s qualifiers list, shown in the accompanying table. Note that while the strategy can hold 30 stocks, today only 18 qualify.
This article does not constitute financial advice. Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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Ian Tam, CFA