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Phil Dabo: Welcome to Quant Concepts. As demand for ESG investing grows, several key trends are emerging from climate change to social unrest. Investors are increasingly implying these factors as part of their process to identify material risks and growth opportunities. Knowing how exposed and how well companies manage their material ESG issues is going to be a critical part of making well-informed investment decisions. We also want to make sure that we are investing in companies that are financially healthy so that we are protected from solvency and liquidity issues.
Today, let's take a look at a strategy that focuses on companies that are financially healthy and relatively better at managing ESG risks. As always, we are going to start by selecting our universe of stocks, which includes all 700 companies in our Canadian database. Next, we are going to rank our stocks from 1 to 700 according to five key factors.
The first factor is the Morningstar quantitative financial health score. This is a proprietary variable that measures the profitability that a firm will fall into financial distress. It uses a predictive model designed to anticipate when a company may default on its financial obligations. The next factors are reinvestment rate because we want companies that are generating enough income to reinvest into profitable growth opportunities. The next factor is the return on total assets, which determines how efficiently the company is using its assets to generate earnings. Our next factor is a return on equity, which is a very popular financial performance metric that incorporates leverage, return on assets and profitability. Our last factor is the 180-day standard deviation to reduce the amount of price volatility in the portfolio.
Now that we have our stocks ranked from 1 to 700, we are going to go through our screening process, starting with the buy rules. We only want companies that are ranked in the top 30th percentile of our list. We are only going to buy stocks that are ranked in the top third based on the Morningstar quantitative financial health score, the reinvestment rate and the return on total assets. We are only going to buy stocks that have a return on equity above 10% and a market cap above 500 million in order to eliminate micro-cap stocks. We want to reduce the amount of price volatility in the portfolio. So, we only want companies that have a standard deviation that is better than the average of our list.
Our last two buy screens relate to ESG. We want an overall ESG risk rating in the top third of our list, and we want companies that are less controversial. This is based on Sustainalytics' assessment of controversies using new screens based on over 35,000 sources.
Now, let's take a look at our sell rules. We are going to sell stocks if they fall out of the top half of our list. We are going to sell stocks if their financial health deteriorates and falls to the bottom third of our list. We are also going to sell stocks if they become more controversial and if their ESG risk rating drops to the bottom third of our list.
Now, let's take a look at performance. The benchmark that we used is the S&P/TSX Total Return Index, and we tested this strategy from January 2012 to September 2021. Over this time period, the strategy generated a very strong 16.7% return, which is 8.5% higher than the benchmark and only a 21% annualized turnover. We can see by looking at the annualized returns that the strategy didn't perform as well as the benchmark over the one-year period, but has performed well over longer periods of time, especially when looking at the three and five-year returns. We can also see that this strategy has slightly higher price risk when looking at the standard deviation. However, this strategy has superior risk-adjusted returns as you can see by the Sharpe Ratio. It's no surprise here that this strategy has lower market risk as you can see by beta.
I really like this performance chart because it shows very strong outperformance of the strategy compared to the benchmark. And when looking at the up and downside capture ratios, we can see that this strategy has performed very well in down markets while still participating nicely in up markets, showing that overall, this strategy has performed well throughout different market cycles.
This is a great strategy to consider if you are looking for companies that are in a strong financial position and are effectively managing their ESG risks. It's also great for investors that are looking for higher-quality companies that have growth characteristics as well. You can find the buy list along with the transcript of this video.
From Morningstar, I'm Phil Dabo.
Find the buy list here.
