Picking stocks with strong balance sheets

These stocks outperformed in both upmarkets and downmarkets, while still keeping volatility low, says CPMS’ Emily Halverson-Duncan

Morningstar Canada 25 January, 2019 | 6:00PM
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Emily Halverson-Duncan: If you were given an offer to buyout a company you probably wouldn’t accept without first doing research or at least hopefully not. You'd likely want to understand more about the business, any potential competitors and perhaps most importantly understand the company's financial strength.

One of the best places to look to evaluate a company's financial strength is their balance sheet. Being able to understand what the company has going for them as well as any obligations they have against them will give you a much clear numerical picture as to whether the company would make a good purchase.

Picking a successful portfolio of stocks requires that same level of discipline, just on a larger scale. Through whatever research tools you have available at your disposal you need to understand whether the companies you invest in are in good financial shape and decide if they are worthwhile investment.

Today I'm going to showcase strategies that searches for stocks which have a strong balance sheet while still focusing on keeping volatility at a lower level. So let's take a look.

To build this strategy I'm first going to rank the stocks in our universe. In Canada we have about 700 stocks that are in our universe and I'm going to look at three different factors when ranking them. The first of which is long term debt-to-equity. Buyback yield which looks at the percent of shares a company has repurchased over the past year, in that case we want a higher value. And then five year beta versus the S&P TSX. So beta looks at the sensitivity of a stock compared to the index and again in this case we want a lower sensitivity.

After doing our ranking we're going to go through and screen out the stocks that we don’t want to own. So we end up with a list of stocks that we're willing to buy. So to do that if you have the screens we used for example long term debt-to-equity we put a cap on that of 1 meaning that we don’t want to be having more debt than we do equity. A few other examples we have here debt-to-cash flow less than or equal to 2. Similar type of idea there we don’t want to have too much debt for the amount of cash that we have available and then the beta that we discussed before to have less than or equal to 1, meaning that it's less sensitive than the market.

On the sell side we would be selling stocks that have their long term debt to equity raise above 1.5 times and debt to cash flow raising above 3. So let's see how that performed. What I am going to do here is run a back test o see how the model did over time. For this back test I'm going to be running it from January of 2000 until end of December 2018. And I am going to hold a total of 15 stocks. So let's see how this back tested.

Alright then so this model actually did quite well over that time period. We've got an annualized return of 19.8% which is quite strong. And that actually beat the benchmark by 14.4%, all the while keeping the turnover at 23%. Turnover again looks at the number of stocks that you would be trading in any given year. So you are flipping less than a quarter of those stocks in that time frame which is quite strong.

A few other things to note here. We can see if we look at the percent of times the model has outperformed in both upmarkets and downmarkets. In upmarkets it outperformed 52% of the time so pretty much even either way. But in downmarkets outperformed 89% of the times so very strong in terms of downside protection.

So overall this model seems to have done quite well in terms of performance and also protecting on the downside. As always though it's always important to make sure you are doing your own research before purchasing any of the names listed here.

From Morningstar I'm Emily Halverson-Duncan.

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