Quant Concepts: Momentum without the volatility?

Holding high-growth companies can be a roller coaster ride that's hard to stomach, but there are tools to help you find opportunities, shows CPMS's Emily Halverson-Duncan

Emily Halverson-Duncan 17 January, 2020 | 1:09AM
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Emily Halverson-Duncan: Welcome to Quant Concepts. Traditional momentum strategies are typically associated with extremes, extreme highs and lows, extreme turnover and extreme risk. These portfolios are usually best suited for active, aggressive investors with a high risk tolerance. While the long-term returns can be quite attractive, the accompanying volatility tends to be too much for the average investor to stomach. Today's strategy will incorporate some of the elements of a momentum strategy while placing a cap on each stock's market sensitivity in the hopes of reducing risk on the downside. So, let's take a look at how to build that.

First off, as always, we're going to rank or universe of stocks. Here, our universe is all the Canadian stocks in the CPMS database. That's about 704 names. So, the factors that we're going to use to rank – quarterly earnings momentum, that's looking at how much earnings are growing or not growing quarter over quarter. Ideally, you want them to be growing. So, a higher value for that is better. Five-year normal cash flow growth. That's looking at a company's track record of cash flow across the last five years and seeing whether or not they're growing it on an annualized basis. Return on equity, another growth metric. And lastly, quarterly earnings surprise, which looks at whether or not stocks have been beating what they're expected to report on earnings or missing. Again, in that scenario, you'd want a higher volume.

After we rank the universe, we're going to go ahead and apply some screens. So, most of the screens here are going to be momentum focused. Some of the examples here are quarterly earnings momentum, we want it to be positive. So, again, you're wanting to see companies growing their earnings. Five-year cash flow growth; we're wanting to see that in the top half of peers. So, right now, that has a value of 4.63% or higher. And then, on the more sensitive side, the risk side, we have a beta cap. So, here we've got our five-year price beta less than or equal to 1.1. So, what that's looking at is a stock's price sensitivity compared to that of the index. A value of 1 means it's as sensitive as the market. So, we're going to allow it to go a little bit more sensitive since we're dealing with more momentum focused names, but we're not wanting it to go extremely more sensitive than the market.

On the sell side, we're going to sell if a stock drops more than 15% across the last month or more than 15% in the last day. So, we're trying to beat out any stocks that are showing some very strong downward trends. And now, we can see how the strategy did over the long term. So, our backtest we're going to be running is from October 2002 until December 2019 and there's going to be 15 stocks run.

Okay. So, this model performed very well, 20.4% annualized across that time period, which represents an outperformance of 11.5% compared to the benchmark, which in this case is the S&P/TSX Composite. Turnover is at 78%. So, it's a little higher than what we've seen in some of our past strategies. What that means is roughly three quarters of the holdings that you have would be traded within a year. Some of the metrics to look at though, despite the fact that it's a momentum strategy, so you'd expect it to do really well overall in performance, we also want to look at risk, because that can be a little bit higher on these types of strategies. So, downside deviation, which looks at the volatility of negative returns for the strategy is 6.9; for the benchmark, it's 8.2. So, the strategy actually has better downside protection, and that's likely due to that beta cap, adding in an additional risk overlay on the model.

Additionally, my favourite charts I like to look at are the green and blue charts here. What we're looking at is how the models have done in both up and down markets. So, in up markets, the model has outperformed the benchmark 63% of the time, but in down markets, it's actually outperformed 86% of the time despite being a momentum-focused strategy. So, all this goes to show even if you are maybe a less risk-tolerant investor than what you would typically picture for a momentum strategy, there could be some other options for you that can do well in terms of performance.

For Morningstar, I'm Emily Halverson-Duncan.

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Emily Halverson-Duncan  Emily is Director, CPMS Sales at Morningstar

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