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Phil Dabo: Welcome to Quant Concepts' working from home edition. There's often been a comparison between the value and growth styles of investment management. Growth stocks have outperformed more recently as companies like Shopify have been the driving force on the S&P/TSX. However, the value style of investing has outperformed over longer periods of time.
Value investing focuses on stocks that are under-appreciated by investors and the market at large. The stocks that value investors seek, typically look cheap compared to the underlying revenue and earnings of their businesses. Investors who use the value style of investment management hope that the stock price will rise as more people come to appreciate the true value of the company's fundamental business.
Today, let's take a look at a strategy that focuses on small and mid-cap value stocks. We're going to start by selecting our universe of stocks. And today, that's all of the Canadian stocks in the CPMS universe. Today, that's 700 stocks, we're going to rank our stocks from 1 to 700 according to four key factors. The first factor is our price-to-earnings, which is a measurement of how much investors are willing to pay for a share of the company's earnings. We want companies that have a low P/E ratio. The next factor is our price-to-cash flow, which is a measurement of how much investors are willing to pay for a share of the company's cash flow. We also want to see a low price-to-cash flow ratio.
The next factor is the beta to the TSX. We want companies that have a lower beta because it shows that they're less correlated to the market. At the same time, the model will inevitably identify smaller cap stocks because they're less correlated to the broader TSX. The last factor is our quarterly free cash flow momentum because we would like to see companies that have been generating a good amount of cash from their business.
Now let's take a look at our buy rules. We're only going to buy stocks that are in the top 10th percentile of our list. We only want to buy stocks if their beta is less than 2. We want to focus on small and mid-cap stocks. So, I've placed a maximum limit on the market capitalization of $11 billion. I also don't want to buy stocks that have a debt-to-equity that is higher than 65% of their peer group. I also want companies that have a decent return on equity and are in the top one-third of our list. This is a basic measurement of financial performance that measures how much income a company can earn with the amount of equity outstanding. My last buy rule is the price change to 12 months high, which is a good momentum factor with downside protection. Companies trading near their previous 12 months high tend to continue doing well.
Now let's take a look at our sell rules. Our sell rules are very straightforward. We're only going to sell stocks if they drop out of the top 20th percentile of our list.
Now let's take a look at performance. The benchmark that we've used is the S&P/TSX Total Return Index and we tested this strategy from January 2002 to January 2021. Over that time period, this strategy has generated an outstanding return of 18.2%, which is 11% more than the benchmark and only a 55% annualized turnover, we can see that this strategy has outperformed over every significant time period. However, it's done that with a much higher price risk as measured by the standard deviation and also with more market risk as measured by beta. The good news is that this strategy has generated strong risk-adjusted returns as measured by the Sharpe ratio.
By looking at this chart, we can see that this is a strategy that has performed well over time. By looking at the market capture ratios, we can see that it's a strategy that has performed well throughout different market cycles. However, it is a strategy with significantly higher volatility. This is a great strategy to consider if you believe that small and mid-cap stocks will outperform and if you believe that value investing will come back in favour. This is also a strategy for those that are comfortable with the inherent risks of investing in small-cap stocks, such as lower trading volume.
You can find the buy list along with a transcript of this video.
From Morningstar, I'm Phil Dabo.
