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Phil Dabo: Welcome to Quant Concepts working from home edition.
This year we’ve seen large cap stocks perform quite well throughout the pandemic. Shopify has returned almost 170% and companies such as Newmont Gold, which is the world's largest gold mining company, have contributed nicely to the S&P/TSX this year. Although small-cap stocks haven’t seen as much headline news, they can add meaningful diversification benefits and alpha to your portfolio. Today let's take a look at a small-cap growth strategy that has performed well over both short and long time periods.
We’re going to start by selecting our universe of stocks which is all of the Canadian companies with a complete dataset. From there we’re going to rank our stocks from 1 to 700 according to 5 key factors. The first factor is the reinvestment rate using trailing earnings per share over the last 12 months. We want to see companies successfully reinvesting their earnings into growth opportunities. The second factor is based on the estimated reinvestment rate over the next 12 months. The next factor is our quarterly earnings surprise. Not only do we want companies that successfully reinvest their earning but we also want companies that consistently beat analyst expectations. The fourth factor is based on quarterly free cash flow. We would like to see small-cap companies that are consistently generating cash from their business operations. Finally, we want to see companies with lower market risk measured by BETA.
Now that we have our stocks ranked from 1 to 700 according to our 5 key factors we want to go through the buy screens to create our buy list. We only want stocks that rank in the top 10th percentile of our list. We only want stocks that have a market cap of less than $2 billion. We’re only going to buy stocks with a return on equity above 8% which is a good growth metric. Our final buy screen is based on a factor that I really like called the price change to 12 month high because in theory stocks that are trading near their high in the previous 12 months tend to continue doing well. We want to buy stocks that are in the top third of our list based on the previous 12 month high.
Our sell rules are very simple. We’re only going to sell stocks if they drop to the bottom 50th percentile of our list.
Now let's take a look at the back-tested performance. The beginning of the test period is January 2005 and the benchmark is the S&P/TSX Small Cap index. We can see that the strategy has outperformed over each and every significant time period. We can see that the strategy has a lower market risk measured by beta and lower price volatility as measured by the standard deviation. Ultimately, this strategy has generated much better risk-adjusted returns than the index when looking at the Sharpe ratio. Although this is ultimately a higher risk small-cap strategy, we can clearly see that it performs much better than the general small-cap index. This is also supported by the up and downside capture ratios that look much better than the index as a whole. When looking at the since inception return, the strategy has done almost 10% better than the index and although the turnover is a bit high we can see by the returns that the strategy provides good buy recommendations.
This is a great strategy for investors that are comfortable with the inherent risks of buying small-cap stocks. It can also provide some great ideas if you’re looking to add diversification to your portfolio with companies that sometimes go unnoticed.
For Morningstar, I’m Phil Dabo.
