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Joshua Farruggio: Welcome to Quant Concepts. It's been a volatile start to the year as investors deal with high oil prices, global supply chain disruptions, Russia's war in Ukraine, and rising rates to battle inflation. While this environment screams risk-off, it's the perfect recipe for momentum-oriented investors as they look to capitalize on the up and down movements of the market. It may not be a viable strategy for all; however, if coupled with risk factors, more investors may be open to this approach as it provides added safety.
Today, we'll take a look at the Canadian market and focus on stocks that exhibit strong price, earnings and cash flow momentum combined with risk factors.
Let's 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 using a few key factors. The first factor is our quarterly earnings momentum. This is the rate of change in quarterly operating earnings. The second factor is our quarterly cash flow momentum, looking at the rate of change of quarterly cash flow from operations. The third and fourth factors will be looking at price change momentum in the last three months and six months.
After that, we'll be looking at three risk factors, weighted approximately 8% each, the first being earnings variability, representing the volatility of a company's reported earnings. We'll also look at the annualized standard deviation of daily total returns for the last three years. And finally, we'll look at our cash flow to debt ratio.
Now, let's apply our buy rules. We are going to buy stocks that are ranked in the top 30th percentile of our list. We'll be looking for companies with a quarterly cash flow momentum above 1.5%. To measure earnings variability, we are going to place a median score to pick stocks that have less variation from quarter-to-quarter reports. We'll also do the same for a stock's price movement in the last three years. In addition, we'll filter for companies that have the ability to service their debts, placing a letter grade of a B+, or in this case, 0.72 cash flow to debt ratio. Finally, to ensure proper liquidity in the model, we will apply a median score for a stock's average monthly value traded.
Now, we'll take a look at our sell rules. We are going to filter out stocks if they deteriorate and fall from the top 45th percentile. If a company's cash flow to debt ratio falls below the bottom third of the universe, we will sell. And finally, we'll sell if a company isn't generating enough cash flow from quarter-to-quarter, in this case, below negative 3.89%.
Let's take a look at performance. The benchmark that we used is the S&P/TSX Composite Total Return. And we tested this strategy from December 2006 to May 2022. Over this time period, the strategy generated an annualized return of 12.1%, almost 6% higher than the benchmark and a 79% annualized turnover, which is acceptable for a momentum model. This strategy has significantly outperformed every annualized period in our backtest. As most momentum models produce, the strategy presents a higher price risk, but 0.5% lower downside deviation than the benchmark. We also notice risk-adjusted returns double the amount of the TSX and lower market risk with a beta of 0.8.
Let's take a look at the green and blue charts below. We have beaten the index by 61% in up markets and 70% in down markets, displaying our ability to capitalize in all environments. This is a great strategy to consider if you are a momentum-oriented investor looking to tone down risk. Companies exhibit strong price and earnings momentum while proving sustainable cash flow and good risk metrics. In the last 3.5 years, the model has produced a cumulative return of 86%, beating the market by 34%. You can find the buy list along with the transcript of this video.
From Morningstar, I'm Josh Farruggio.
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