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Phil Dabo: Welcome to Quant Concepts working from home edition. Small cap stocks can be very nice to add to your portfolio because they have the potential to generate very high returns. But there are also a lot of risks as well. Illiquidity is one of the risks that comes with purchasing small cap equities. But there are also additional business risks as well. Some smaller companies might not have a long history of operational success, whereas other companies might seem a lot better than they really are when looking at the income statement. This is why the cash flow statement can provide good information on management and how they're generating and using cash. Today, let's take a look at a strategy that focuses on small companies that have really good short-term cash flow metrics.
As always, we're going to start by selecting our universe of stocks, which includes all 700 companies in our Canadian database. Then we're going to rank our stocks according to five key factors. The first two factors are the quarterly and annual cash flow momentum, because we're looking for companies that have recently generated more cash than they have in the past. Next, is our cash flow to debt, because we want companies that are generating really good cash, but we don't want them spending all that cash to finance debt. This is a good metric to make sure that the company is generating significantly more cash in relation to the debt that they have on the balance sheet. Next is our market float because we want to bias toward large cap companies that have a market cap of less than $1.8 billion. Our last factor is beta. In order to reduce the market volatility in our portfolio. A beta of less than 1 means that the stock is less risky than the broader market.
Now that we have our stocks ranked from 1 to 700, we can start going through the screening process. We're only going to buy stocks that are ranked in the top 25th percentile, and we're only going to buy stocks with a market cap of less than $1.8 billion, but above $64 million. We want the cash flow to debt to be in the top third, and also want to reduce the price volatility by using the 180 day standard deviation to eliminate companies that have a price that moves more than 30% of the best stocks in the database. The last factor is the enterprise value to EBITDA, which is a popular metric used in corporate finance to assess the value of a company. Here, we want stocks that have an enterprise value to EBITDA better than the worst 70% of companies in our database.
Now let's take a look at our sell rules which are very simple. We're going to sell stocks if they deteriorate and fall out of the top 50th percentile of our list. And we're also going to sell stocks if their cash flow to debt deteriorates and falls out of the top third of our list.
Now let's take a look at performance. The benchmark that we use is the S&P/TSX Small Cap Total Return Index. And we tested the strategy from January 2006 to June 2021. Over this time period, the strategy generated a very strong 17.2% return which is now expanding 13.6% higher than the benchmark, with a slightly higher annualised turnover of 78%. We can see by looking at the annualised returns, that this is a strategy that has generated significantly superior performance over longer periods of time, such as a 3, 5 and 10 year compared to the benchmark. It's done so with slightly lower price risk as you can see by the standard deviation, which contributes very nicely to higher risk adjusted returns, as you can see by the Sharpe ratio.
In addition to having higher risk adjusted returns, this strategy also has superior alpha. And it also has lower market risk, as you can see by beta. Again, looking at this performance chart, we can see very good performance over time. And when looking at the up and downside capture ratios, we can see that this is a strategy that has performed really well in down markets, but still contributed really nicely in up markets. Overall, this is a strategy that has performed well throughout different market cycles. This is a great strategy to consider if you're interested in small Canadian companies that have less volatility than the S&P\TSX Small Cap Index. In addition to generating really good alpha and risk adjusted returns compared to the index, the buy list focuses on companies with strong short-term cash flow metrics. You can find the buy list along with the transcript of this video. For Morningstar I'm Phil Dabo.
