What are we looking for?
U.S. small caps showing consistent profitability.
The screen
This week, I use Morningstar CPMS to look for U.S. stocks with a relatively small market capitalization that have shown good profits and a history of stable earnings. To find these companies, I first rank the stocks in the S&P SmallCap 600 Index by the following factors:
- Latest reported net profit margin (latest four quarters of earnings per share expressed as a percentage of revenue over the same period, higher figures preferred);
- Five-year variability of earnings (a statistical measure showing how volatile a company’s earnings have been over the past five years, lower figures preferred);
- Latest reported return on equity and return on total assets (both profitability measures, higher figures preferred).
To qualify, companies must be ranked in the top 25 per cent of the S&P SmallCap 600 based on the above factors. In addition, companies must have a debt-to-equity ratio less than one; this limits us to the lowest two-thirds of stocks in the index in terms of debt-to-equity and helps us avoid overly leveraged 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, 1998, to March, 2018. During this process, a maximum of 15 stocks were purchased and equally weighted with no more than three stocks per economic sector. Once a month, stocks were sold if their rank fell below the top 25 per cent of the ranked universe or if the company missed earnings expectations by more than 5 per cent. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio keeping in mind the aforementioned sector limits.
Over this period, the strategy produced an annualized return of 18.3 per cent while the S&P SmallCap 600 gained 10.1 per cent. In calendar year 2008, this strategy lost 17.8 per cent while the small-cap index fell 32 per cent.
The stocks that meet our requirements for purchase are listed below. 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.
Ian Tam, CFA