Quant Concepts: Focus on the Fundamentals

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Phil Dabo: Welcome to Quant Concepts' working from home edition. Volatility has come back to an all-time high for the year with so much uncertainty coming from geopolitical risks, unexpected inflation, and rising interest rates, with some investors fearing that there might be another recession coming around the corner.

With all of this uncertainty, it can be even more important to focus on corporate fundamentals, which include top-line growth coming from revenue, which eventually leads to higher bottom-line growth after deducting expenses to arrive at net income. It's also important to look for companies that have their debt levels under control because higher interest rates can create more liquidity and solvency risks. Today, let's take a look at a strategy that focuses on companies that are financially healthy and have higher sales momentum accompanied by higher earnings momentum.

As always, we are going to start by selecting our universe of stocks, which includes all 700 companies in our Canadian database. Then we are going to rank our stocks according to four key factors. The first two factors are the annual sales momentum to capture top-line growth and the annual earnings momentum to capture bottom-line growth. Essentially, companies that are able to generate really good sales and keep their costs relatively lower will be able to generate higher income. Our next factor is market capitalization because we would like to place more emphasis on larger companies. Our last factor is the price relative to the three-month moving average, because it does a really good job of capturing price momentum.

Now that we have our stocks ranked from 1 to 700, we are going to go through our buy rules. We are going to buy stocks that are ranked in the top 30th percentile, and we are going to buy stocks with a market cap above $500 million, which pretty much eliminates all microcap stocks. We are going to reduce price volatility by using the 180-day standard deviation and focusing on companies that are ranked in the top third. We also want companies that have really good financial performance. So, we've placed a limit of 15% on the forward return on equity. We are only going to buy stocks that are ranked in the top third based on the price change to 12-month high because we've found that stocks trading close to their previous 12-month have continued to perform well.

The next three factors are intended to reduce the volatility by finding companies with stronger fundamentals. I've used the earnings variability to find companies ranked in the top third based on their consistency in reported earnings, and I've used the debt to EBITDA to find companies in the top third based on the debt relative to their operational earnings. Lastly, I used the Morningstar quantitative health score, which is a really good proprietary metric to find companies ranked in the top third that are least likely to default on their financial obligations.

Now, let's take a look at our sell rules, which are very simple. We are going to sell stocks if they fall out of the top 60th percentile of our list. We are also going to sell stocks if they fall out of the top third based on the Morningstar quantitative financial health score and based on the debt to EBITDA.

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 February 2022. Over this time period, the strategy generated a very strong 13.6% return, which is 6.9% higher than the benchmark and only a 26% annualized turnover, showing that this is a very good buy and hold strategy. When you're looking at the annualized returns, we can see that the strategy outperformed the benchmark over every significant time period, and it's done so with lower price risk as we expected, and you can see that from the standard deviation.

This has contributed to superior risk-adjusted returns, as we can see by the Sharpe Ratio, and it's also important to note that this strategy has lower market risk, as you can see by beta. When looking at this performance chart, we can see very good outperformance over time, which is pretty impressive for a strategy that has really good downside protection. 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 it still performed quite well in up markets, showing that 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 companies that have strong fundamentals and can provide some downside protection to your portfolio. The strategy has outperformed the S&P/TSX in every negative calendar year. You can find the buy list along with the transcript of this video.

From Morningstar, I'm Phil Dabo.