Stocks of high-quality companies have outperformed their peers in 2023. ‘Quality’ is one of Morningstar’s seven investment factors, and measures a company’s profitability and debt-to-capital ratio. It is an indicator that helps determine a stock’s long-term value.
As Morningstar researchers explain, shares of companies with strong profitability and sound balance sheets have historically outperformed their less-profitable and more highly indebted counterparts. The shares of these companies have also proved to be less volatile than the broader market, and tend to be more resilient during downturns. The investor who overlooks a firm’s quality rating may be passing over a key measurement of long-term durability and growth.
Two Cheap, Quality Canadian Stocks
- Power Corporation of Canada
- West Fraser Timber Co. Ltd
Where to Find High-Quality Stocks?
The Morningstar Developed Markets Quality Factor Index is a pool of securities that meet our quality criteria across all developed economies. This index has returned 8.50% so far this year, compared to 3.65% for the broader Morningstar Developed Markets Index.
As many investors are looking for quality, high-quality stocks tend to be more popular. As my colleagues Paul Kaplan, Tom Idzorek and James Xiong, along with Yale’s Roger Ibbotson explain in their book Popularity: A Bridge between Classical and Behavioral Finance, investors are willing to pay more for securities with popular characteristics and less for securities with unpopular characteristics. This causes popular stocks to have lower returns and unpopular stocks higher returns. Thus, investors who are willing to hold unpopular stocks will, over the long run, earn higher returns than other investors.
Put another way, popular high-quality stocks tend to be more expensive.
There still are some high-quality opportunities for Canadian investors. Here, we’ve highlighted two Canadian companies in the Morningstar Developed Markets Quality Factor Index that are curently undervalued.
Power Corporation of Canada Excelled Against It’s Large-Cap Peers
Power Corpotation of Canada
- Ticker: POW
- Stock Price: $35.72
- Morningstar Fair Value Estimate: $40.00
Power Corporation of Canada, a holding company with assets primarily in the financial services sector, has excelled against its large-cap Canadian peers so far in 2023. The stock has returned 12.15% YTD, compared to the 1.36% year-to-date return of the Morningstar Canada Large Cap Index.
The bulk of the company’s value comes from two sizeable Canadian financial firms: Great-West Life (GWO), which offers life insurance, retirement recordkeeping, and investment management, and IGM Financial (IGM), an asset and wealth management firm.
Great-West Life is one of Canada’s Big Three life insurance providers, and benefits from a diverse product lineup. As Morningstar equity analyst Suryansh Sharma explains, a disciplined underwriting strategy and proactive expense management has historically lifted Great-West’s returns on equity.
Power Corporation of Canada’s other significant holding, IGM Financial, is the largest non-bank affiliated Canadian asset manager. It earns a narrow Economic Moat Rating mainly due to switching costs and intangible assets. According to analyst Greggory Warren, “IGM Financial has historically generated solid operating margins and maintains a leading share in the Canadian mutual fund market.”
West Fraser Timber is Tied to Canada’s Housing Boom
West Fraser Timber Co.Ltd
- Ticker: WFG
- Stock Price: $98.37
- Morningstar Fair Value Estimate: $139.00
West Fraser Timber is one of North America’s largest softwood lumber producers. Its revenue mainly comes from new construction and remodeling projects, which closely ties the business to housing market fluctuations and overall economic conditions, as analyst Spencer Liberman explains.
The correlation of housing demand and affordability with West Fraser’s profitability exposes the company to significant macroeconomic risk. However, according to Liberman, the firm has proven stable, having continuously operated with very low leverage and low near-term debt maturities. Its recent acquisition of Norbord, a leading producer of oriented strand board, further expanded West Fraser’s offerings into engineered wood products.
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