Quant Concepts: Steady Returns and Modest Income Strategy

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Brandon Strong: Welcome to Quant Concepts. As the S&P/TSX continues to slide, it is becoming increasingly difficult for investors to pinpoint the right equities. Some investors may disagree and point to the outperformance seen within the energy sector and state, well, these are the stocks you want to buy. Although the sector has been performing well, especially in Q1 2022, it is not the most risk-adverse industry to be fully invested in during a potential market downturn. That is why we think it is best to switch from a more aggressive strategy to a strategy that is more conservative in nature. By doing so, we aim to reward investors in the form of steady return and modest income until confidence is restored in the market.

Today, we are going to look at a unique feature within CPMS that allows us to combine two strategies into one. We'll combine a strategy with a focus on growth at a reasonable price and an income strategy with a smidge of momentum built in. So, let's get right into it.

Let's start by ranking our universe of around 700 stocks, and here, we are starting with our GARP strategy. In the ranking step, we are going to look at 10 different factors, which you can see here. The first factor is price to forward earnings, which is the ratio of a company's latest price to its forward-looking earnings per share. Next, we have reinvestment rate, which is the rate at which a company is expected to reinvest earnings back into its business and is a common measure of growth for a company.

Next, we have earnings variability, which represents the volatility of a company's reported earnings per share on a quarterly basis. We have price to book, which is the ratio of a company's latest price to its per share value of its common share equity. And additionally, we have quarterly earnings momentum and quarterly earnings momentum for next quarter, as one is using a trailing number and the other is using an estimate of next quarter's EPS. Moreover, we have quarterly earnings surprise, which is a proprietary measure of the percentage difference between actual and expected earnings for the latest reported quarter.

Next, we have estimate revisions, which measures the percentage change over the past three months in the current fiscal year median earnings estimate. This factor is very important for capturing analyst sentiment. And lastly, we have price change from three months ago and price change from six months ago, a few momentum indicators to round out the strategy.

Now, let's run through the screening process. As you can see here, we are only going to select stocks that are in the top 50 of our list. The reinvestment rate factor on current year median EPS needs to be above the median of the universe to qualify in our strategy as we want these companies reinvesting their earnings back into the business. The earnings variability factor needs to be above a D+, which would be in the top two-thirds of the universe based on their variability of earnings.

Quarterly earnings momentum and quarterly earnings momentum for next quarter need to be above negative 1% and negative 3%, respectively, as we are looking for a positive or slightly negative momentum at a minimum. And lastly, we need sufficient liquidity. So, we added a buy rule on volume of greater than or equal to the median of the universe.

Next, let's take a look at our sell rules. In this case, we have kept things very simple with only two sell rules. We are going to remove stocks that fall below the 200th name on our list. And we'll screen out stocks that have quarterly earnings momentum less than negative 5%. Next, we'll dive into the momentum yield strategy. In the ranking step, we are going to look at three main factors, which you can see here. The first factor is RP200DA, which is the current price of a stock relative to its 200-day moving average. Next, we have RP50DAV, which is the current price of a stock relative to its 50-day moving average. And lastly, we have PCHGHI, which is the percentage change in the price of a stock from its 12-month high, each with an equal weight.

Now, let's run through the screening process once again. As you can see here, we are only going to select stocks that are in the top 50th percentile of our list. The yield for this strategy needs to be above a B- as we are looking for income generated from this arm of the pooled strategy. The payout ratio on current year median EPS needs to be below 100% as more than that would signal that the company would not be able to sustain the dividend long term. Lastly, similar to what we saw with the GARP strategy, we included a volume screen of a C- to make sure that we have sufficient liquidity.

Next, taking a look at our sell rules, in this case, we've kept things very simple once again, with only three sell rules. We are going to remove stocks that fall below the 75th percentile of our list. We will screen out stocks that have a yield below a D-. And lastly, we will sell the stock if the payout ratio exceeds 120%.

Now, let's take a look at our back test. And before we do that, I want users to keep in mind that this output is based on the two strategies we outlined a second ago, and you can see here that they both have a 50-50 allocation. So, going back to our back test page, we've started the period from January 2000 and ran it until April 2022. Over that time period, we've seen notable outperformance over every timeframe, and we've kept our turnover relatively low, with only 46% annualized turnover.

Taking a look at the standard deviation, which is here, we can see that there has been lower standard deviation of return since inception, and although the standard deviation has climbed recently, our strategy is relatively close to the index across the majority of the time periods. This contributes to greater risk-adjusted returns as measured by the Sharpe Ratio, and we can see that this strategy has lower or equal beta over every time period except the one-year number. And lastly, we can see significant alpha generated from the strategy.

I also like to take a look at the market capture ratios down here. We can see that this strategy has a notable downside capture ratio, which indicates that this strategy holds up during market downturns. It tends to beat the S&P/TSX in more quarters than it doesn't. Again, if you are looking for a strategy with a healthy blend of growth, value, income and momentum, please make sure to check out the buy list accompanying the transcript of this video.

From Morningstar, I'm Brandon Strong.

Find the buy list here.