What's driving Canada's top performing stocks today?

Ian Tam: As we enter the second quarter of 2019, Canadian equities seem to be on a high velocity trajectory of positive gains recovering swiftly from the correction in late 2018. This said, it's very likely that conservative investors who have a focus on quality names may lag in the recent performance of our index. Today, I use Morningstar CPMS to have a peek behind the curtain to see what is driving this market performance.

So, to do this analysis I first took a look at the largest 250 names in Canada by market float and I actually isolated the top 50 best-performing stocks year-to-date. That list is shown on my screen here in front of me. So, we have Village Farms, Champion Iron, TransAlta Corporation. Again, strictly based on the year-to-date price return, I took a look at the top 50 names in Canada today.

To have a look at what's driving the performance of these stocks I use the Morningstar CPMS Factor Attribution Report to understand what the fundamentals are of these 50 stocks.

So, on my screen here is again the Morningstar CPMS Factor Attribution Report. And the idea behind this report is to measure a number of different fundamental metrics of the index in this first column and compare those same fundamental metrics for a portfolio. So, here what I did was I took those 50 best-performing stocks, I assumed a market-float weighted portfolio to make it a fair comparison against the TSX, which is also a market-float weighted index.

So, reading the top line here just to break down how this chart is read, if I held all the stocks in the S&P/TSX Composite or perhaps held an ETF of the index, my debt to equity ratio today would be roughly 0.6 times. If I held all 50 of the best-performing stocks this year, again, in a market-float weighted portfolio, my debt to equity would be 0.9 times. That would imply that I'd be a bit more leveraged – in fact, I'd be 40% more leveraged than just simply holding the ETF. Similarly, you will see that the historic beta of the portfolio that I hold is 1.5. That implies that for every $1 that the TSX moves up, this portfolio of stocks has historically moved up by $1.50. Similarly, the other way around as well. So, if the index moves down by $1, our portfolio of stocks would have lost $1.50. So, a very volatile or a very sensitive set of stocks when compared against the TSX Composite.

One last thing I noticed here is that the deviation of earnings seems to be higher as well. So, again, the deviation of earnings basically measures how stable a company's historic earnings have been. So, a company like a Canadian bank, for example, would have very stable earnings over time. Or a company like a small-cap mining company might have very volatile earnings. And for a conservative investor, you may prefer to have more stable earnings. So, here the portfolio of those 50 stocks actually shows a substantially higher historical volatility of earnings than the broad index.

So, this goes to show that the best 50 performing stocks seem to be a little bit more risky. Some of them are a bit more leveraged, they have higher sensitivity to the index, and they seem to have more volatile earnings. Looking further down on this analysis, we also look at our valuations. So, on a price to earnings, price to book, price to sales ratio, you can see that those 50 stocks after a very strong rally seem to have market-like valuations.

Finally, if you look at some of the shorter-term growth metrics of those same 50 stocks, a few things kind of came out at me. The first is quarterly earnings momentum. And quarterly earnings momentum is a very short-term measure of earnings growth that compares the last four quarters of operating earnings against the same number one quarter ago. And for these 50 stocks in particular, that growth rate of earnings seemed a little bit higher than the index. We also noticed that earnings surprise which is basically a measure of what the company reported versus what the street consensus on earnings was just prior to the company reporting, that earnings surprise number, of course, looked a little better for these set of 50 stocks.

These metrics that I just mentioned in terms of short-term growth, they are fairly volatile in nature, meaning, they can change very quickly. So, when analyst sentiment changes, or market sentiment changes, you can see that those will go up and down. But they are also typically a driver of stock price.

So, what we can take away from this analysis is that the 50 best-performing stocks this year seem to be a bit more volatile. That being said, people that were paying attention to this list, will have noticed that a number of the stocks in my best performers list seem to be related to Canada. For example, Village Farms which was historically a manufacturer or a producer of organic cucumbers, tomatoes and such recently pivot away from that and started to produce cannabis products. Similarly, you will see OrganiGram Holdings, HEXO Corporation are all cannabis. Again, this is a fairly recent phenomenon in Canada, the development of this sector or this industry. So, one may wonder how this analysis would look if we had excluded those cannabis stocks.

And of course, I did this analysis. So, on the screen here you will see the exact same factor attribution report this time excluding cannabis names which was about eight names in my list. And you will see that the analysis doesn't really change that much. So, even excluding cannabis companies you will see the companies that have done well still seem to be a bit more risky with reasonable short-term growth metrics over the last quarter.

Through this analysis one thing is clear. The best-performing stocks this year leave much to be desired for a fundamentally conservative stock picker. As a portfolio, the companies that have done well seem to be fairly volatile and of lower quality. When lower quality stocks are rewarded, the market is seeking risk or chasing returns. This is reminiscent of what we saw back in 1999 pre-tech bubble, 2009 after the financial crisis and more recently in 2016. Over the long-term though, remaining disciplined and picking quality names will likely provide a better glide path for you to reach your financial goals.

For Morningstar, I'm Ian Tam.