Ian Tam: As we approach the RRSP contribution deadline in Canada for a calendar year 2018, many retail investors are likely on the hunt for reasonable names that are meant to be held long-term in the tax sheltered account. Today, I used Morningstar CPMS to come up with a strategy that looks for reasonable names that may fit this criteria. So, when you think about investing for an RRSP, you're often thinking about long-term growth, capital preservation and possibly some dividend yields. So with those ideas in mind, turn your attention to the pie chart on my screen. As you know I typically create models that first rank stocks based on a number of factors. So this week, with that RRSP retirement investment in mind I use these specific factors.
You'll see that 25% of my model is based on what I called 'deviation around five year earnings per share'. So, basically what we're doing here is we're looking for companies with very consistent earnings, not small-cap mining companies for example that have earnings that are all over the place. We much prefer nice steady earnings like a bank or maybe a consumer staples company for example.
In a simple frame of mind I also look at five-year beta. So, if you recall, beta measures the historical sensitivity of a stock against a particular index. So, because we are looking at Canada, we actually use the S&P/TSX as composite as our main benchmark. So when we have a beta that's less than 1 what that means is that stock historically when the benchmark or the index moves up our stock moves up less than the index. More importantly though when the stock – sorry when the index moves down our stock moves down less and that's really what we're looking for. We're looking for companies that not overly volatile when compared to a specific index in this case the TSS composite.
Also just of note here I use a 'five-year' which is a fairly long-term measure of beta and of course I prefer companies that have lower betas relative to the TSS composite. So, those are two fairly large pieces of my model today and they're worth of a 50% of a stocks ranking. Of course, I also look at dividend yields, most people know what dividend yields are, basically it’s the dividend paid divided by the price of the stock and of course, we want higher yields.
In addition to that the last three slices of the pie here look at pretty medium or long term growth of a company. More specifically, I'll look at five year earnings per share growth, which is basically their growth of the bottom line. We also look at five year sales growth, which is the growth of revenue or the top line and we also look for five year cash flow growth, which could often point to the ability for a company to actually continue to pay dividends into the future.
So, with this pie chart, what I've basically done is taken these factors and I've use them to rank all the stocks that are covered by Morningstar CPMS from number 1 to number 700, which is the total universe of companies that we cover at Morningstar CPMS.
Now for us to create an actual model, what I've done is also after I put everything in order, I start to screen all companies that are perhaps less desirable. So, a couple of things. In order to consider buying a stock, I only consider the top 25% of those 700 companies after I put them in order based on that pie chart. I also look at companies that pay a dividend yield better than 3.75%, that may seem like a weird number. What that represents is the median dividend yield across the 700 stocks today.
Also look for a companies with a market cap that are greater than $107 million, again, that seems like an odd number. What I'm really doing there is excluding the bottom third of stocks, by market cap again out of the 700 companies that we cover.
Just below that, I also reference dividend payout ratios. So, when you're a dividend investor, it's very important to have nice conservative payout ratios. We saw this back in the oil crunch of 2014 when companies like Baytex Energy suddenly starting out – started to payout more dividends that they were making in earnings. And that of course is not sustainable. You can't payout more than you make as a company. So, the measure that defines that is called payout ratio. So, for a stock to be considered in my model today, I need a payout ratio that's less than 80% on earnings or less than 60% on cash flows. So, that in essence makes up a number of very specific screens that excludes companies out of the Morningstar CPMS database.
Now this third step in my process, and I'm going to test this for you in a moment, but the third step is the self-discipline. That's the most important part of investing in general. It's very easy to convince yourself when to buy a stock, it's very difficult to have the discipline to know when to sell a stock and that's where the CPMS methodology I think is very strong and very clear.
So, what I've done in my model today is I've said that if a stock's rank, which again is based on that pie chart, if the rank drops below the top of 35% or top – roughly the top third of those 700 stocks, I'm going to sell the stock. Secondly, if the company starts paying out too much dividends, meaning they are not going to be sustainable in the future, again measured out by payout ratios, I'm going sell that stock. Thirdly, if the company suddenly starts to report negative earnings, I'm going to sell the stock. If the estimates on the Street turn negative, I'm going to sell the stock and I also look at the change in estimates. So, if analyst sentiment turns substantially negative, I'm going to sell the stock.
So, through these three steps, I've essentially built in fancy finance terms a quantitative model. And by having a very structured process in investing, I'm actually able to test them all to see how it would have done, how do I follow these rules over a very long amount of time. So, I'll do that for you now. Again using Morningstar CPMS, I'm going to run a back test. So, again what's happening here is I am starting a portfolio of maximum 15 stocks back in April of 1995. So, in April of 1995, we would have purchased the 15 stocks that met my requirements using the information available at that point in time. In my strategy today, I did limit the number of stocks per sector to four. So, I never own more than four stocks per sector, just to make sure I am not overly concentrated in one sector which again can be fairly risky.
So, what's happening in this chart in the background here is that at the end of each month, I am checking to see if any of the stocks I hold, break my sell rules and when they do, I sell that stock and I immediately replace it with the next highest ranking stock, again never owning more than four stocks per economic sector. So, we're just running through that same process that I explain to you over and over again in this case for the last 30 years or so.
So, you can see on the screen here that after running that roughly 30 year back test, this particular model or strategy returned about 15.8% annualized which actually beats the S&P/TSX Composite, my benchmark by about 7.7%, which again fairly impressive but keep in mind, they didn't put any management fees or commission rates in here. So, in real life, of course, we need to taper that down to account for any sort of trade fees that you may incur as a self-directed investor.
It's also important to note here as couple of key metrics, the Sharpe ratio for those that are unfamiliar. The Sharpe ratio basically measures the return per amount of risk that you are taking on in your portfolio. So, of course, you want a nice, high Sharpe ratio, which in this case, we actually have a 1.5 Sharpe ratio which is much higher than the index which just give you a 0.4. So, this speaks to the risk efficiency of this style of investing which seems to have worked pretty well, the beta of the portfolio, so all 15 stocks in tandem is about 0.3, so historically for every dollar the benchmark moves up, we move up 0.3, but again for every dollar the benchmark moves down, we only move down 0.3, which is quite a defensive characteristic.
Moreover, I'd scroll down a little bit on this page, you will see there are a certain number of quarters in the last 30 years or so where the TSX showed a negative return. Of those quarters, our strategy beat that benchmark about 78% of the time. So, for an RRSP or retirement investments account, it does make sense to keep in mind a very defensive strategy something that preserves you capital, especially in down-markets, which I think we are able to do successfully here.
So, the companies that meet their requirements to be purchased today into the model are going to be listed in the table attached to the video transcript.
Table 1
- Data as of Market Close February 26th, 2019. Source: Morningstar CPMS
Table 2
- Data as of Market Close February 26th, 2019. Source: Morningstar CPMS
Of note is the North West Company Incorporated, which is about $1.5 billion market cap stock that’s engaged in retail business, in underserved rural communities and urban neighborhoods. The company provides food, family apparel, housewares, appliances, and mostly food products that account for the majority of the company's revenue. North West operates businesses in Northern Canada, Western Canada, rural Alaska, the South Pacific Islands, and the Caribbean, with about two-thirds of the total revenue coming from the Canadian market.
For Morningstar, I'm Ian Tam.
