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Phil Dabo: Welcome to Quant Concepts working from home edition. Small cap stocks have done fairly well recently with the S&P/TSX SmallCap Total Return Index, generating a 44% return over the past year, while the broader S&P/TSX Total Return Index generated a 28% return. Even though small cap stocks have done so well, we can still find companies trading at a discount to their intrinsic value. Although some of these companies might be too volatile for some investors, and might lack the liquidity for others, they can still find meaningful diversification benefits, especially when combined with large cap growth stocks. Today, let's take a look at a strategy that focuses on small cap stocks that are trading at a discount.
Now let's take a look at the strategy. We're going to start by ranking our universe of stocks which includes all 700 companies in our Canadian database. Next, we're going to rank our stocks according to four key value metrics, and three momentum metrics. The first two value metrics are the price to book and the price to cash flow. The price to book ratio is the market value of a company divided by the book value. And it's an indication of how much you're willing to pay for the book value of the company. The price to cash flow is fairly straightforward, and it's an indication of how much you're willing to pay for the operating cash flow of the business.
The next value factor is the price to earnings ratio, which is an indication of how much you're willing to pay for the earnings of the business. Our last value factor is the price to sales ratio, which is an indication of how much you're willing to pay for the sales of the business. When all of these value factors are taken into consideration. We're looking for companies that are trading at a discount, but have really good cash flow, earnings, sales and a high net book value. The next factor is our first momentum factor, which is a three month earnings revision, because we want to find companies that analysts have a positive outlook for. The next two momentum metrics are the three month price change and the six month price change in order to capture the momentum in the price of the stock.
Now that we have our stocks ranked from one to 700, we're going to go through our screening process starting with our buy rules. We're only going to buy stocks that are ranked in the top 25th percentile of our list. And we're only going to buy stocks that have a return on equity above 15%. This is a very good financial performance metric that incorporates leverage return on assets and the profit margin. We want to focus on small cap stocks, we've placed a minimum market cap limit of $260 million and a maximum market cap limit of $2.4 billion. Our last buy rule is the Morningstar quantitative financial health score, which is a proprietary metric that makes it easier to determine whether a company is in good financial health. And we do this by measuring the likelihood that it will fall into financial distress. Here we want to eliminate companies that are ranked in the bottom third, based on the financial health score.
Now let's take a look at our sell rules which are very simple. We're going to sell stocks if they fall out of the top 30th percentile of our list. And if their financial health deteriorates and falls to the bottom 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 the strategy from January 2006 to September 2021. Over this time period, the strategy generated a very strong 15.2% return which is 8.8% higher than the benchmark with an 82% annualized turnover, which is quite normal considering the momentum variables that we have in the strategy. When looking at the annualized performance numbers, we can see that the strategy outperformed the benchmark over every significant time period. And it's done so with higher price risk as you can see by the standard deviation, which is quite normal considering this is a small cap strategy. That being said, the strategy still has higher risk-adjusted returns as you can see by the Sharpe ratio, while having market like risk as you can see by beta.
When looking at this performance chart you can see very strong outperformance over time. And when looking at the up and downside capture ratios, we can see that this strategy is one that has outperformed in up markets, which has contributed to a very strong overall market capture ratio. This is a great strategy to consider if you're looking to add some diversification to your portfolio with smaller companies that have lower valuation numbers. This strategy has performed very well over the past 15 years with the only negative calendar years being 2018 and the 2008 financial crisis. Most of the companies on the buy list are suitable for investors that have a higher risk tolerance and are comfortable with the inherent risks of buying smaller companies such as illiquidity.
You can find the buy list along with a transcript of this video. From Morningstar, I'm Phil Dabo.
Find the buy list here.
