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Phil Dabo: Welcome to Quant Concepts working from home edition. We've seen the growth style of investment management perform very well over the past 10 years. These companies typically have a lot of opportunities available to them. So they will reinvest more of their earnings into their business. A lot of these stocks will also have higher relative valuation ratios, such as the price to earnings and price to book and they'll also have lower payout ratios. Tech companies are known to be more growth-oriented and they've performed very, very well recently.
Today, let's take a look at a strategy that focuses on growth-oriented stocks and offers a lot of diversification across different sectors. As always, we're going to start by selecting our universe of stocks, which includes all 2,000 stocks in our U.S. database. Next, we're going to rank our stocks according to seven key factors. The first two factors have to do with the forecasted reinvestment rate, which has a total weight of 35%. And the third factor is the trailing reinvestment rate. The next two factors are the annual earnings momentum and five-year growth in earnings per share. Next, we have the median earnings per share growth next year, which is a forecasted number. And our last factor is the three-month price change in order to capture a bit of momentum in the stock price.
Now that we have our stocks ranked from one to 2,000, we can start going through the buy and sell rules. We're only going to buy stocks that are ranked in the top 25th percentile of our list. We're only going to buy stocks with an annual earnings momentum above 10%, and five-year earnings per share growth rate above 15%. The next factor is the sum of analyst estimates, which needs to be above 5 to make sure that our forecasted reinvestment rates are based on sufficient data.
The last two factors are meant to reduce volatility. So I've included the 180-day standard deviation to reduce price risk, and the debt to EBITDA to make sure that a company is generating enough income to pay down their debt. 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 40th percentile of our list. We're also going to sell stocks if the annual earnings momentum falls below 0%. And the five-year normal earnings per share growth rate drops below 5%. In order to reduce the volatility in the portfolio, we're going to sell stocks if the price becomes too volatile based on the 180-day standard deviation. And if the debt to EBITDA deteriorates and falls to the bottom third of our list.
Now let's take a look at performance. The benchmark that we use is the S&P 500 Total Return Index. And we tested the strategy from December of 1999 to July of 2021. Over this time period, the strategy generated a very strong 16.9% return which is 9.7% higher than the benchmark with this 65% annualized turnover. We can see when looking at the annualized periods that the strategy outperformed the benchmark over every significant time period and outperformed the S&P 500 by almost twice as much over a 20-year period.
It's important to note that this strategy has higher price risk, as you can see by the standard deviation, but it also has significantly higher risk-adjusted returns, as you can see by the Sharpe ratio. It's also worth noting that there is comparable market risk as you can see by beta, but I really like to look at this chart which shows a very strong outperformance by the strategy over the past 20 years. And when looking at the up and downside capture ratios, we can see that this is a strategy that performs very well in up markets, showing that when the strategy does go through periods of underperformance, it does bounce back very quickly, which has contributed very nicely to an overall market capture ratio, showing that this is a strategy that has performed well throughout different market cycles.
This is a great strategy to consider if you're looking for stocks that are reinvesting into their business instead of distributing cash to shareholders in the form of a dividend. Typically investors that are interested in these stocks would want to grow their money over time because they don't need income from their investment. Most of the companies on the buy list are either large or mega-cap stocks, and we've placed a limit of five stocks per sector in order to encourage diversification. You can find the buy list along with a transcript of this video.
From Morningstar, I'm Phil Dabo.
To see the buy list, click here.
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