Quant Concepts: Value alone is not enough

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Ian Tam: Welcome to Quant Concepts. In a cyclical market like Canada being a purely value-based investor is often a challenging endeavor, partially due to the influence of commodity prices that drive a large portion of the Canadian economy. Remember that together the materials and energy sectors make up almost 30% of the S&P/TSX Composite. Swings in supply and demand of said commodities often come with volatility in stock price, even if a company is considered undervalued fundamentally.

When considering factors to look for, some may consider combining value, momentum and quality metrics together to find a more suitable strategy for your investment profile. This week, I use Morningstar CPMS to do just that.

So, if you have a look at my screen here, I've built a model that does exactly what I mentioned, combining value, momentum and quality together. And as you know, to build a model, we often pick factors that are important to us. And in CPMS, we use those factors to rank a list of stocks from best to worst.

So, on my screen, here, I have three value-oriented or value-based factors. I look at price to earnings, but not just the price to earnings ratio itself, I compare the price to earnings today compared to the 10-year median of the price to earnings of that same stock. So, basically, we're looking for a P/E ratio that's close, or hopefully below the historic median of that company. I also look at price to book. And as a reminder, the book value represents the firm's equity if we liquidated all the assets today. So, basically, assets minus liabilities would give you your book value of equity. So, we take price to book as our second value metric, and we're comparing today's price to book against the last 10-year, whatever that median number is. And of course, we want that to be hopefully close or lower than it has been historically. Similarly, I also look at price to sales, again, relative to the 10-year median price to sales of the same stock. So, those are the three value metrics I use, and together, they make up about one-third of my model.

In terms of momentum, I'm using two metrics today. I'm using the percent change from the 12-month high. I'm also using price change from – basically, the last six month price change. So, the percent price change from 12-month high is kind of a counterintuitive measure in that we're actually looking for companies that are trading close to their 12-month high. So, again, for a value investor, it doesn't make sense. But for a momentum investor, specifically in Canada, through our research, we've actually proven that this factor is often effective in momentum-driven markets, which Canada can often be. So, together, the price change from 12-month high and the price change from six months ago, that's worth about one-third of my model as well.

And finally, I look at a couple of quality-oriented metrics. First, I'd look at the deviation of earnings across five years. So, again, we're looking for companies that have fairly consistent earnings over time. And we're also looking at the average ROE or return on equity over the last five years. And we want a nice high number there. So, again, the quality metrics, deviation around earnings as well as five-year average ROE, those make up the last third of my model.

So, if you look at this pie chart here, these factors basically determine the rank of the stocks in my model. And today, I'm considering the Canadian universe of stocks which is roughly 700 companies within Morningstar CPMS.

Now, for me to consider buying one of these stocks, a few things have to happen. After we put those stocks in order, the stocks that I pick must be in the top quartile, or the top 25% of that list after I put it in order. In addition to that, again, I want to make sure that the value metrics that I'm looking at are close or hopefully below their 10-year historic median. So, I put a 1.1 limit, meaning if it's 10% higher, that's still okay, but we want a combination of all three metrics to be below that 10% threshold. We also want the company to have positive return on equity. We want the market flow to be greater than $821 million. That's in Canadian dollars. We're ignoring unit trusts and REITs today in our model. And lastly, we want the estimates from the Street to generally be moving in the positive direction. And I'm measuring that over the last three months.

Now, most importantly, we also want to look at our sell rule. So, this is what our sell discipline is, and this is what drives the turnover in my model today. So, what I'll do is, if the stock's rank dropped below the top 35%, so roughly the top third of my universe, I will sell the stock. If the return on equity suddenly turns negative, I will sell the stock. And lastly, if the estimates on earnings over the last three months dropped by more than 10%, I will again sell that stock. So, again, I'll use Morningstar CPMS to back test this model for you just to show you how it would have performed over a very long period of time.

So, again, you can see on the screen here, we're starting with $1 million cash. And what we're going to do is back in 1992, I would have purchased 15 stocks that met my requirements at that point in time with no more than three stocks per economic sector just to make sure I'm somewhat diversified across the Canadian economy. At the end of each month, I'm checking to see if any of those stocks that I hold break my sell rules. If they do, I sell them and I immediately replace them with the next highest ranking stock, again, never owning more than three stocks per sector.

Okay. So, just wrapping up our back test here, you can see that over that timeframe from May of 1992 to the end of June 2019, the strategy returned about 15.1% annualized, which is better than the S&P/TSX Composite by about 6.1%. Again, I have not included any fees here. So, keep that in mind as you look at the results of this model. The turnover in the model is about 40%, meaning on average every year you're trading about a bit less than half of the stocks in and out of the portfolio.

Another very important measure to look at again is the Sharpe Ratio. Sharpe Ratio represents the return per unit of risk that you're getting for investing. Sharpe Ratio of 1 is considered fairly good. The Sharpe Ratio of the index over that same time period is 0.4. So, of course, a Sharpe Ratio of 1 for our model actually looks fairly attractive. So, the stocks that meet the requirements to be purchased into the model today are listed in the table accompanying today's video and transcript. Our top ranked stock is CI Financial, a diversified provider of wealth management products and services, primarily for the Canadian market.

For Morningstar, I'm Ian Tam.