What are we looking for?
Less-loved companies with strong free cash flows and growing but stable earnings.
The screen
This week, I use Morningstar CPMS to develop a strategy that focuses on companies that are not widely followed by research analysts and as such, may not have as reliable forward-looking estimates when compared with a larger company with multiple analysts making projections. That said, there is a plethora of literature that emphasizes the "small-firm effect" (the idea that over the long run smaller firms, which perhaps fewer people are paying attention to or actively trading, are able to outperform larger companies). Today's strategy looks to capitalize on this anomaly by ranking stocks in the Morningstar CPMS database by:
- Free-cash-flow yield (derived by subtracting capital expenditures from operating cash flows and dividing the difference by enterprise value. The idea is to look for companies that have “free” cash to be able to reinvest for future growth, or perhaps pay a dividend – higher figures preferred);
- Five-year earnings per share growth rate (on average, how much has the company grown their earnings each year in the past five years, higher figures preferred);
- Deviation around five-year EPS growth rate (a factor that measures how volatile a company’s earnings have been over the trailing five years, lower figures preferred);
- Annual and quarterly earnings momentum (the trailing four quarters of operating earnings compared against the same figure four quarters ago and one quarter ago, respectively – higher figures preferred).
To qualify, companies must have no more than three active analysts covering the stock. To ensure some liquidity, only companies with a market cap greater than $125-million were considered (this threshold excludes the bottom one-third of stocks by market cap in the CPMS database, which today consists of 713 Canadian companies).
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 August, 2004 to January, 2018.
During this process, a maximum of 15 stocks were purchased and equally weighted. Once a month, stocks were sold if their rank fell below the top 40 per cent of the ranked universe, or if quarterly earnings momentum fell by more than 5 per cent. When sold, the positions were replaced with the highest ranked stock not already owned in the portfolio.
As a buffer to account for the less liquid nature of these names, a 1-per-cent liquidity cost was applied to each transaction (sold positions received 1 per cent less and bought positions cost 1 per cent more in each historical transaction).
Over this period, the strategy produced an annualized total return of 13.4 per cent while the BMO Nesbitt Burns Canadian Small Cap Index advanced 6.1 per cent.
The stocks that meet our requirements for purchase are listed in the accompanying table. It is always recommended to speak to a financial adviser or investment professional before investing. In particular, investors must heed the intricacies when trading less liquid small-cap stocks.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.