Quant Concepts: Go with a growing cash flow

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Ian Tam: Welcome to Quant Concepts. The idea of a rising interest rate environment might be on the backburner for many investors, with the most recent announcement from the U.S. Fed of an interest rate cut on the backdrop of a trade war with China. The Bank of Canada has also kept rates steady, also pointing to tensions between the world's two largest economies. What this means is that, for the meantime, rising costs of debt are going to be less of a concern for corporations.

This being said, it's still very important for investors to keep an eye out on corporate cash flow, because it affords the Company the financial flexibility to reinvest in projects, whether economic downturns and, of course, pay dividends to shareholders. So, even if higher debt costs are no longer a front-of-mind concern, cash flows are still very important.

Today, I'll use Morningstar CPMS to build a Canadian model that sees companies with growing cash flows.

So, to start off with, I'm going to look at a number of cash flow specific factors available within Morningstar CPMS. The first factor I'll look at is the five-year growth rate of operating cash flows. So, this points to on average, how much operating cash flows are growing each year in the last five years.

I also look at free cash flow yield, and free cash flow yield is calculated as the operating cash flow minus capital expenditures, divided by the enterprise value of the company. And that's worth about 20% of my model.

Also going to look at annual and quarterly cash flow momentum. These metrics compare the last four quarters of operating cash flows against the same number four quarters ago and one quarter ago, respectively. Together, those two short-term growth metrics are worth about 30% of my model.

And finally, to add an element of safety, or low volatility to my model, I also look at the standard deviation of total returns over the last 180 days. So, this essentially measures how volatile the stock price is and, of course, I want less volatility in the movement of the stock.

That's what makes up the factors that I will focus on. And I'll use these five factors to rank all the stocks in the CPMS Canadian database, which is about 710 companies, from best to worse. Now, for me to consider buying a stock, I'm only going to look at the top quartile or the top 25% of that list after I put everything in order.

Within that top 25%, I also want to make sure that the stocks are liquid enough for me to trade. So, here, I'm actually going to use a market float limit of about $850 million. That means that in order to qualify, the company has to be at least $850 million in terms of its market float. That number also represents the top third of market float in Canada today.

And finally, I also want to make sure that the dividend or the company pays some sort of a dividend. I don't really necessarily care how big that dividend is, but it has to pay some sort of a dividend. As well, I want to make sure that the yield or the dividend yield is greater than the median of the sector to which that company belongs.

To define my sell discipline, which is the most important part for many investors, I will determine that if the stock drops below the top 35% or roughly the top third of the stocks in my universe, I will sell that stock, or if the company stops paying dividends, I will also sell that stock. So, that's what defines my model today. What I'll use is use Morningstar CPMS to back test this strategy to see how it'd have done over a fairly long period of time.

So, as I'm running the back test, I want to just quickly remind everybody, what happens in a back test is we're going to start with some amount of cash. Here I've used $1 million. And I'm also going to use a fairly concentrated 15-stock portfolio. So, in April 2004, when I started this back test, I would have used that cash to buy the 15 stocks that met my requirements at that point in time. At the end of each subsequent month, I'm going to check if any of those stocks break my sell limits. If they do, I sell them and immediately replace them with the next highest ranking stock, never owning more than four stocks per economic sector, just to make sure I'm reasonably diversified across the economy.

So, you can see from my back test results here, the annualized return on that strategy is about 12.6%. This is going to be gross of fees; so I have not baked any sort of management fees or transaction costs in here. So, make sure you keep that in mind. That is better than the S&P/TSX Composite by roughly 5.1%. And the turnover on the model is about 40%. So, a bit less than half the stocks are created in and out of the model every single year.

Of course, we also want to look at some of the risk metrics. So, if we look at all the quarters over the last 15 years or so where the market was down, our strategies today beat the index about 75% of those quarters. Overall, in up-quarters and down-quarters, the strategy beat the market about 63% of the time. So, this speaks to the defensive nature of this type of model that does focus on cash flow growth within a company.

Also, I want to point out the Sharpe ratio, which again is the risk adjusted return or the amount of return per unit of risk that you're taking on. So, the Sharpe ratio for this particular model over the longest time period is about 0.9. The Sharpe ratio for the index over that same time period is about 0.5. So again, this model is a bit more risk efficient, or I would say, substantially more risk efficient than simply buying the index, even though it is a pretty concentrated portfolio.

So, the companies that meet the requirements to be purchased into the model today are listed in a table accompanying the transcript for this video.

For Morningstar, I'm Ian Tam.