Quant Concepts: Best of both worlds

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Emily Halverson-Duncan: Welcome to Quant Concepts' virtual office edition. When selecting investments for your portfolio, investors often search for securities which have characteristics that they like, dividends, low valuation, large market cap and so on. One method of achieving these chosen attributes is to apply all of them to your investment universe and select stocks from the companies that remain. Another method to consider is to split up your desired attributes. For example, if you are looking for income but also want stocks with upward momentum potential, you can consider those as two different styles and create portfolios to match each one. In today's video, we are going to construct a model out of two different sleeves, one emphasizing dividends and the other momentum. Each sleeve will focus on its respective style only and then the final portfolio will be a 50-50 combination of the two. So, let's take a look at how to build that.

First off, we are going to start with the income sleeve of the model. So, our universe here is 694 Canadian stocks. As always, first off, we are going to rank that universe of stocks. The factors that we're going to use here in the income model are 5-year dividend growth. So, we are looking at a higher 5-year annualized number, representing that the company has been paying and growing dividends over a long term. Expected dividend growth which looks at what a company is expected to pay on their dividends compared to what they did pay out in the last year. And again, we want a higher value for that. And lastly, a little bit of momentum factor here – quarterly earnings surprise looks at whether a company has beat or missed on their expected earnings. Again, we want a higher value or an outperformance on earnings there.

In terms of screens that we're applying here – that 5-year dividend growth factor, we want it to be in the top third of peers which today has a value of 9.66% annualized or higher, meaning that on an annualized basis, they are growing their dividends about just under 10%. Expected dividend growth, we want that to be positive. Earnings per share payout, we want that to be less than or equal to 75%. So, what that's looking at is, of their earnings how much are they paying out in dividends. The reason for capping it at about 75% is we want to make sure they've got cash left over afterwards from their earnings to reinvest back in the company for future growth potential.

On the sell side, we are going to sell stocks if that 5-year dividend growth value drops below at the bottom half of peers. So, that would be below 3.47% today or if that payout ratio rises above 80%, so if they are paying out more than 80% of their earnings in dividends. So, that's the first sleeve of the strategy.

The second one is our momentum, which is just jumping over here. Same universe that we're going to look at, so 694 Canadian names. And then, in terms of ranking, the factors we're going to consider, we've got that same momentum one, quarterly earnings surprise. Again, we want to have a higher value for that. Quarterly earnings momentum, which looks at whether or not a company is growing their earnings quarter-over-quarter. So, higher values for that are preferred. And price change from the stock's 12-month high. That's another momentum factor and we want to see that again on the higher side.

In terms of screens that we're applying, both quarterly earnings surprise and quarterly earnings momentum, we want to see them to be positive, so greater than 0.01. Price relative to 200-day moving average. This is more of a timing factor, so when to enter into a particular company. What that's looking at is a stock's price relative to the stock's 200-day moving average price, and we want that to be greater than or equal to 3%, so essentially 3% above that moving average level. 5-year beta, we want that to be less than or equal to 1. And again, remember beta looks at a stock's price sensitivity. And then, lastly, market cap, we want that to be in the top two-thirds of peers. The reason there is, we are just trying to screen out those really small-cap companies that are less liquid or sometimes more volatile as well.

On the sell side, we just have one simple sell trigger, which is that price relative to the 200-day moving average. If that dropped below minus 15%, so the stock's price is trading 15% below the 200-day moving average, we're going to sell that stock out of the portfolio.

So, let's take a look at how the back test did. The back test here we're buying 10 stocks from each sleeve, so 10 income stocks, 10 momentum stocks and then applying a 50% weight to each of the sleeves. We ran that back test from January 2004 until end of April 2020 and compared that to the TSX. So, annualized return here was 14.5% which represented an outperformance of 8.1%, so very strong performance across that timeframe. Turnover wasn't too bad, about 58%; 20 stocks total, that's trading, let's say, 11 or 12 stocks on average per year.

Few other metrics that I always like to look at – downside deviation, so that's the volatility of negative returns, for the strategy is 7.7% and for the benchmark is 9.6%. So, a lower downside deviation indicates that this model would typically do better in down markets. And again, my favourite blue and green chart here that I always like to look at. In up markets, this model outperformed 55% of the time, whereas in down markets, it outperformed 77% of the time. So, gives you a really good indication that the blend between momentum and income while you get that really strong outperformance, it still manages to hold its own and do well in down markets. So, for yourself, if there are multiple characteristics that you like and they may be slightly different in nature, so momentum and income is an example here, it might be worthwhile splitting those out and picking stocks based on each type of attribute and then combining them together for one final portfolio.

For Morningstar, I'm Emily Halverson-Duncan.