Undervalued U.S. stocks that could rebound

What are we looking for?

Value-focused stocks within the U.S. large-cap universe.

The screen

Value investing is a popular investment style used to get exposure to stocks that appear to be worth less currently than they are expected to be worth in the future. While simple in theory, in reality, it can be difficult to correctly predict what stocks will rise once deemed undervalued instead of continuing to fall.

Today I’ve created a strategy that focuses on large cap U.S. companies that are seen as undervalued relative to their peers, while trying to avoid stocks with high debt that are more at risk to continue falling in value. This strategy ranks stocks based on:

• Price to trailing earnings (measured as the company’s most recent share price divided by the previous four quarters earnings per share; low values preferred);
• Free cash flow (a profitability metric; high values preferred); and
• Price to cash flow (ratio of a company’s price relative to it’s most recent four quarters of cash flow from operations; low values preferred).

In order to qualify, stocks must have both a market cap greater than half of peers (today this value is greater than $3.2 billion) and trailing P/E in the bottom 2/3 of all U.S. stocks (that value today is less than 26.8). Company’s debt/equity ratio must be less than 1.1 to ensure they are not over levered. Lastly, stocks must have free cash flow in the top third of peers (today this value is greater than $2.64/share). 

What we found

I used Morningstar CPMS to back test this strategy from April 2004 to March 2018. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their ranking fell below the top 40 per cent of the US universe or if the company’s debt/equity ratio rose above 1.3.

Lastly, stocks were sold if the company’s free cash flow dropped below the bottom third of peers. 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 13.7% while the S&P 500 Total Return Index returned 8.7% across the same period.

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

Emily Halverson-Duncan is a Director, CPMS Sales at Morningstar Research Inc. Morningstar provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, covers more than 95 per cent of the investable North American stock market.