A market-beating portfolio

By Ian Tam on July 31, 2017
Estimated reading time: 3 minutes

How to build an easy large cap portfolio that outperforms the S&P 500 over the long term

Wall Street — (Cultura Travel/WALTER ZERLA)

Unlike the Canadian equity market which is concentrated in three sectors (financials, energy, materials), most equity investors would argue the US market is far more efficient both in terms of available liquidity, and the representation of the full economy with more stocks to choose from within each sector. This being said, the S&P 500 Total Return Index is certainly a tougher benchmark to beat factoring in the added efficiencies when compared the S&P/TSX Composite TR Index. This leaves most Canadian investors who may be looking to take advantage of the recent strength in the Canadian dollar in a bit of a conundrum.

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What are we looking for

A Low-Maintenance U.S. conservative large cap portfolio that outperforms the S&P500 TR Index over the long term. To achieve this, I use Morningstar CPMS* to design a low-maintenance portfolio (with the idea of keeping transaction costs low) that ranks stocks within the S&P 500 TR Index on two simple factors:

Yield on expected dividends. This is the yield calculated by taking the most recently announced, but not yet paid, distribution and dividing it by the most recent stock price)
Five-year historic beta. Recall that Beta is a sensitivity measure. In falling markets, a stock with a beta lower than 1 well have fallen less than the index, while in rising markets a stock with Beta lower than one will rise less than the index. Here we use Beta as a defensive measure, preferring companies lower Beta.

What we found

During this process, 20 stocks were purchased and equally weighted with two stocks per economic sector. Once a quarter, we used dividend proceeds to re-balance stocks back to their equally weighted target. Once a year, we replaced all the stocks in the portfolio with the highest ranked stocks based on the above two parameters. When I used Morningstar CPMS to back test this strategy from December 1993 to June, 2017 I found this strategy produced an annualized total return of 13.4% while the S&P 500 TR Index returned 9.4%.

The stocks that qualify for purchase into the strategy are listed in the table below. As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here:

A conservative large cap portfolio

Rank	Company	Morningstar Sector	Market Cap ($USD Millions)	Yield (%)	5Y Historic Beta
1	Southern Company (SO)	Utilities	$46,994.8	4.9	0.1
2	FirstEnergy Corp (FE)	Utilities	$13,866.9	4.6	0.2
3	AT&T Inc. (T)	Communication Services	$222,742.0	5.4	0.5
4	Verizon Communications (VZ)	Communication Services	$178,309.2	5.3	0.5
5	L Brands, Inc. (LB)	Consumer Cyclical	$12,695.7	5.4	0.6
6	Occidental Petroleum (OXY)	Energy	$45,423.8	5.2	0.7
7	Macy's Inc. (M)	Consumer Cyclical	$6,909.3	6.7	0.8
8	Target Corporation (TGT)	Consumer Defensive	$29,819.8	4.6	0.6
9	Conagra Brands, Inc. (CAG)	Consumer Defensive	$14,097.6	2.5	0.2
10	ONEOK Inc (OKE)	Energy	$11,574.7	5.4	1.2
11	Eli Lilly & Co (LLY)	Healthcare	$93,501.2	2.5	0.3
12	People's Untd Fncl Inc. (PBCT)	Financial Services	$6,081.2	3.9	0.8
13	CH Robinson Worldwide (CHRW)	Industrials	$9,245.1	2.7	0.5
14	Motorola Solutions, Inc (MSI)	Technology	$14,821.7	2.1	0.3
15	Int'l Business Machines (IBM)	Technology	$137,157.2	4.1	1
16	Lyondellbasell Ind NV (LYB)	Basic Materials	$35,142.2	4.1	1
17	Pfizer Inc (PFE)	Healthcare	$198,848.6	3.8	1
18	Grainger WW Inc (GWW)	Industrials	$9,746.7	3.1	0.7
19	CF Industries Hldg Inc. (CF)	Basic Materials	$7,046.8	4	1.2
20	Western Union Company (WU)	Financial Services	$9,029.2	3.7	1.2

Data as of July 24^th, 2017

* Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.

Ian Tam is the Manager of the Client Services team at CPMS, a division of Morningstar that focuses on providing high quality equity fundamental data and disciplined rules-based investment processes to the institutional buyside and investment advisors across North America. Ian completed his Bachelor of Applied Sciences (Hons. Mechanical Engineering) from the University of Waterloo in 2007 and obtained the CFA Charter in 2013.