Predictable growth style has delivered solid results

Criteria focused on valuation, reinvestment rate and consistency help pick stocks likely to outpace the market.

Michael Leonard 7 April, 2014 | 6:00PM
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With the growing popularity of exchange-traded funds (ETFs) in recent years, the decades-old debate between active and passive equity management has intensified. Some observers postulate that there is no reason for investors to pay MERs of 2% or more to active equity managers who often struggle to keep up with their benchmark index when they can own equity-based ETFs at a fraction of the cost.

However, active management is far from passé, as demonstrated through the quantitative approach to equity management at the heart of Morningstar CPMS, a desktop platform designed for institutional equity managers, and Morningstar CPMS Advisor Edition, a web-based interface introduced to enable advisors to follow a family of style-based strategies. Morningstar maintains these strategies on a daily basis to help investors track the performance of various investment styles.

Each strategy uses a combination of weighted preferences on a selection of variables pertinent to the particular investment style. The resulting Buy and Sell strategies combine to create simulated portfolios that can help investors understand which investment approaches are being rewarded by the market and which are not.

The Canadian Predictable Growth strategy is one such strategy, in which three equally-weighted variables together account for more than half of the weight in the stock rankings. First, the price-to-earnings ratio using the median earnings estimate for this year (forward P/E) helps ensure stocks that have low to moderate valuations are favoured.

Second, the projected growth of a stock's book value in percentage terms, also known as the reinvestment rate, is the preferred measurement of a "growth stock" used by Morningstar CPMS. This measure ensures that the strategy favours stocks that are reinvesting significant portions of their earnings in the company to generate future profits, as opposed to paying most or all of these profits out as dividends.

Third, Predictable Growth relies on a calculation proprietary to Morningstar to measure the historic variability of companies' reported quarterly earnings to place preference on companies that tend not to miss their quarterly earnings projections by significant margins. This variable puts the "predictable" in Predictable Growth.

Aside from these metrics, the Predictable Growth strategy also considers earnings surprises, earnings momentum, and price momentum; in each case, the simulated portfolio looks for positive values for these variables, since Morningstar CPMS's proprietary backtest has demonstrated that each adds Alpha to actively managed portfolios.

Among the high-profile stocks currently held in the simulated Predictable Growth portfolio is Magna International Inc. MG. Magna rates very highly on the three aforementioned measures: historically, its quarterly earnings reports have resulted in few large misses either way; its book value is projected to grow by almost 16% this fiscal year, which is better than most publicly-traded companies in Canada; and at 11.8 times, Magna's forward P/E ratio represents reasonable value, despite the stock's good run -- it's up about 22% so far in 2014 (to March 31) and more than 75% ahead in the past 12 months.

Meanwhile, Magna continues to accelerate its earnings growth quarter after quarter and in doing so, to meet or surpass analysts' expectations for quarterly earnings. This in turn fuels upward revisions of fiscal earnings projections by these analysts. Despite the run-up, don't worry about having "missed out" on Magna; positive price momentum has been proven to be a positive attribute for this strategy. So long as Magna continues to meet expectations each quarter, it is likely to outperform the broader market return.

Predictable Growth counts 10 financial services stocks among its 30 current holdings, including most of the big banks. This makes intuitive sense, since banks' earnings are inherently predictable and their forward P/E's are lower than those of many companies in Canada. Another of these 10 financials stocks is the lesser-known Equitable Group Inc. (EQB/TSE), a niche mortgage lender that provides second mortgages on commercial and residential properties. Equitable Group may not be a household name, but its market capitalization is fast approaching $1 billion.

Equitable Group has returned about 23% since it was purchased by Predictable Growth in early October, and it remains a first-percentile Buy in this strategy. The company's book value is projected to grow by 17% this year and yet its forward P/E ratio is a modest nine times.

While many prognosticators and other observers may fret about impending interest rate hikes and what this may do to the Canadian housing industry, all eight analysts who cover Equitable Group have revised their 2014 fiscal EPS estimates upward since Feb. 28, which portends well for the stock.

Since the inception of the Predictable Growth strategy backtest at Dec. 31, 1985, the strategy has returned 14.3% on an annualized basis versus 8.5% for the S&P/TSX Composite Total Return Index. Volatility of returns for the strategy, measured in terms of standard deviation of monthly returns, has been only slightly higher than the market at 16% versus 14.9%.

The Predictable Growth strategy returned 3.8% in the first quarter of 2014, not quite keeping pace with the benchmark return of 6.1%. However, in the 12 months ending March 31, Predictable Growth out-paced the market by a count of 26.4% to 16%. Furthermore, Predictable Growth has returned 12% annualized over three years (to just 3.5% for the market), rating it among the best performers of the suite of Morningstar CPMS Canadian Strategies over this time frame.

Another metric that should increase investors' comfort level in Predictable Growth is its batting average in beating the market: since 1985, this strategy has surpassed the Index 66% of the time when the market return was positive in a calendar quarter, and 59% of the time when the market was down. This translates to quarterly success of 64% in all calendar quarters, which is a very strong figure given that we know that no strategy works all the time.

Annual turnover for this strategy is 78%, which means that on average, investors can expect to hold each stock for about 15 months. This translates to about six sell/buy trades per quarter on average.

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About Author

Michael Leonard

Michael Leonard  Michael Leonard, CFA, is chief equity strategist at Morningstar Canada.

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