How to find stocks that are financially solid

What are we looking for?

Canadian stocks that show strong balance sheet characteristics

The screen

 If you were given the offer to buy out a company, you likely wouldn’t accept without first doing research – or at least hopefully not. You’d probably want to understand more about the business, any potential competitors, and perhaps most importantly, understand the company’s financial strength. One of the best places to look to evaluate a company’s financial strength is their balance sheet. Being able to understand what the company has going for them as well as any obligations they have against them will give you a much clearer numerical picture as to whether or not this company would make a good purchase.

Picking a successful portfolio of stocks requires that same level of discipline, just on a larger scale. Through whatever research tools you have available at your disposal, you need to understand whether the companies you invest in are in good financial shape and decide if they are a worthwhile investment.

Today, my strategy searches for stocks that have a strong balance sheet, while using a couple of other fundamental variables to help mitigate volatility and time appropriate entry and exit points.

This strategy ranks stocks based of off 3 factors:

1. Debt to equity ratio – low values are best;
2. Buyback yield – value of shares repurchased by a firm divided by their outstanding shares; high values are best;
3. Five-year beta – measure of a company’s sensitivity relative to changes in the benchmark – here we use the S&P/TSX; low values are best.

In order to qualify, stocks must have:

• Working capital (a measure of liquidity; difference between current assets and current liabilities) greater than or equal to 0;
• Debt to equity ratio less than 1 to remove highly leveraged companies;
• Debt to cash flow less than 2 to ensure companies have adequate cash on hand to pay off outstanding debts;
• Buyback yield better than two thirds of peers (today this value is 0.35%);
• Price relative to the 200D moving average (a technical indicator) greater than 3%;
• Five-year beta less than 1 to avoid stocks that are highly correlated to changes in the S&P/TSX.

What we found

I used Morningstar CPMS to back test this strategy from January 2000 to December 2017. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their debt to equity rose above 1.5; if their debt to cash flow rose above 3; or if their price relative to their 200D moving average fell below -10%.  When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 18.1% while the S&P/TSX Composite Total Return Index returned 6.3% across the same period.

As can be seen in the following chart, annualized returns outperformed the benchmark across 1, 3, 5, 10, and 15 years, resulting in the +11.8% increase in since inception performance over the TSX.

Downside protection also remained strong across the full-time period, with the strategy beating the benchmark in 75% of down markets. Dispersion of returns also indicated the strategy proved to have a small number of extremely negative quarters and a high number of positive quarters.

Lastly, the strategy’s Sharpe Ratio, a measure of risk-adjusted returns, was very strong at 1.1. Calendar year performance and turnover can also be seen below.

The stocks that qualify for purchase into the strategy today are listed in the table below. Note that only 10 stocks qualify as of today. As always, it is advised that investors conduct their own independent research before buying or selling any security.

These stocks make the cut:

MORE ABOUT STOCKS:

• How to pick stocks for fun and profit
• Get the benefit from investing momentum, with less risk
• Find an edge when investing in TSX ‘dogs’ strategy
• Investors need to watch the accounting on weed stocks
• 10 shared traits of value investors
• Can I claim capital losses from a stock in my RRSP to reduce taxes?
• Screening for top U.S. stock prospects in 2018
• What are pot stock investors smoking?

Emily Halverson-Duncan is an Account Manager with Morningstar Research Inc., which provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers.