Last year was a good year for the S&P/TSX Composite index. In 2019, it clocked a total return of 22.9% – the highest gains since 2009, when it returned a 35.1%. The index started the year on a strong note with a return of 13.3% in the first quarter and ended with a return of 3.2% in the last quarter.
Impact on CPMS strategies
Morningstar CPMS offers 11 Canadian investment strategies, of which three are growth-oriented – and these growth-oriented strategies posted good results in 2019. The Predictable Growth Strategy and the Dividend Growth Strategy produced returns of 30.5% and 25.7%, respectively, while Asset Growth also slightly exceeded the market with returns of 24.1%.
The Predictable Growth strategy is designed for conservative investors seeking growth at a reasonable price. Canadian Dividend Growth is suited for income-oriented investors seeking to buy profitable companies that are growing their dividends. Finally, Asset Growth is for more aggressive investors seeking growth. It looks for stocks with high growth in book value, positive earnings surprises and quarterly earnings momentum.
Focus on financials
The financial services sector was one of the best performing sectors last year, clocking a return of 21.36%. The sector forms the core of many portfolios, as income-seeking Canadian investors gravitate to bank stocks, which usually pay out dividends. As of January 27, 2020, the six major Canadian Banks are rated ‘Buy’ in the Morningstar CPMS Dividend Growth strategy, as are insurance companies Power Corp. of Canada (POW) and Sun Life Financial Inc. (SLF).
But are banks the best way to add income to your portfolio? To test this theory, let’s look at the CPMS Canadian Dividend Growth strategy. The strategy emphasizes stocks with:
- High expected dividend yields and dividend growth
- High cash flow momentum (a measure of growth of year-over-year operating cash flow) and return on equity, and
- Positive analysts’ earnings estimate revisions
Based on these three pillars, how do the Canadian banks stack up?
Are banks the best bet?
For five of the Canadian banks, expected dividend growth lands in the top 20% of the CPMS universe. In the Dividend Growth strategy, stocks are also screened to assess their expected dividend yield, which ranks also around the median for all the banks. For the first half of the first pillar – high dividends – the banks do make sense. But that’s about the only good news.
When it comes to annual cash flow momentum (ACFM), things don’t look as good. ACFM measures the rate of change of annual operating cash flow per share (before changes in working capital). It is calculated as the percentage change between the latest 4 quarters of operating cash flow per share and the 4 quarters of operating cash flow from 4 quarters ago. Cash flow momentum as measured by the ACFM is negative or close to zero for most of the banks, except Canadian Imperial Bank of Commerce (CM), the highest-ranked in the strategy which shows an ACFM of 6.6%. This variable is very important since it indicates that a company can continue to afford to pay increasing dividends.
What about earnings estimates? The three-month EPS Estimate Revision is negative for five banks, except National Bank (NA). This variable calculates the percentage change over the past 3 months in the current fiscal year median earnings estimate. For example, a value of 15 for this variable means that the current year median earnings estimate has been raised by 15% over the past 3 months. And other earnings metrics are not encouraging either.
The quarterly earnings surprise, which is a CPMS proprietary measure of the percentage difference between actual and expected earnings for the latest reported quarter, is negative for Canadian Imperial Bank of Commerce (CM) and Royal Bank (RY) and in a range between 0 and 0.4% for the four other banks. The Quarterly Earnings Momentum metric shows similar values. The Quarterly Earnings Momentum variable measures the rate of change of quarterly operating earnings per share (excluding unusual gains or losses). Another major indicator of earnings growth, the estimated EPS Growth for 2020 vs. 2019 suggests that earnings will decline this year for most, if not all, of the big six banks. This limits their potential for stock price gains.
The prospects for the Dividend Growth strategy seem bleak in the medium term if banks don’t improve their earnings.
What are the alternatives?
There are other stocks in the Diversified financial services sector that offer the earnings growth the banks don’t – with healthy dividends, for example, large cap financial companies like TMX Group (X), or insurers like Genworth MI Canada (MIC), Sun Life Financial (SLF) and Great-West Lifeco (GWO), that show the same characteristics as the banks.
Other names include Equitable Group (EQB) that has a better Expected Dividend Growth than the banks with a much stronger cash flow and EPS estimate revision value, and higher quarterly earnings momentum, and iAG Financial Corporation (IAG). IAG has solid cash flow, an EPS Estimate Revision that is higher than that of the banks, and a better quarterly earnings surprise and QEM. It also pays great dividends.
Finally, the star, which is a ‘Buy’ in most CPMS strategies, Home Capital Group Inc., (HCG). It does not yet pay dividends (although management reportedly is contemplating doing so) but has a strong cash flow. Furthermore, its EPS estimate revision, quarterly earnings surprise and quarterly earnings momentum ranks in the first 20% of the universe.
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