Quant Concepts: Investing in extreme valuations

Valuations are sky-high right now - does that mean there are no opportunities left? CPMS's Emily Halverson-Duncan makes a model that may surprise you

Emily Halverson-Duncan 24 January, 2020 | 1:46AM

 

 

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Emily Halverson-Duncan: Welcome to Quant Concepts. Valuations measured by the price to earnings ratio of the S&P/TSX Composite have been trending higher over the last year and as such can give the impression that stocks may be getting too expensive. But if that's the case, does that mean that there's no opportunity left in the Canadian market?

Today I'm going to explore this question by creating a strategy that looks only at stocks in the extremes of the market. Either extremely high valuations or extremely low valuations, both of which are typically assumed to be unattractive. The strategy aims to create a portfolio of stocks that performs well without an excessive amount of risk despite being considered unappealing from a typical valuation standpoint. So, let's take a look at how to build this.

First off, we're going to rank the stocks in our universe, which is the Canadian CPMS universe. Right now, there are 702 stocks in that universe. The factors that we're going to use to rank, annual cash flow momentum that's looking at the growth of cash flow year-over-year we'd want that to have a higher value. Quarterly earnings surprise looks at whether or not a stock has beat what they were expected to report for earnings, again, we're looking for a higher value. And 12-month price change relative to stocks high this is a momentum factor and again, we're looking for a higher volume.

On the screening side, we have a few different screens related to both value and momentum. So, first off to look at the extremes of the market, we're going to look for a price to trailing earnings, which is a value factor that's either in the bottom six of the universe or the top six. So, what that means is we're looking for a price to trailing earnings that's greater than or equal to 29.54, which is a very high or less than or equal to 10.39 times. So again, we're looking in the extremes typically, you'd probably want to be somewhere in the middle of those numbers. But in this case, we're going to go to the extremes for this question.

Annual cash flow momentum and quarterly earnings surprise, we want those both to be positive. Five-year price beta, which is a measure of how sensitive a stock is compared to the index, which in this case is the TSX, we want that to be less than or equal to 1 so sensitive or less sensitive than the market. And lastly, cash flow to debt we want to be in the top third of peers, which is a value of 0.36 or higher.

On the sell side, we're going to sell stocks if the annual cash flow momentum or the quarterly earnings surprise drops below 2%.

So, let's see how this does across the long term. Here we're going to run a backtest of 15 stocks. The timeframe for the backtest is going to be January 2000 until December of 2019.

Okay, so backtest was extremely strong the strategy performed 23.6% annualized across that time frame, which is an outperformance of 17.4% over the benchmark. Turnover was on the high side at 105%. Again, we're purchasing 15 stocks. So, what that means is on an average year, you're going to be trading all 15 of those stocks and buying 15 new stocks throughout the year. A few of the risk metrics that I always like to look at downside deviation, which looks at the volatility of negative returns was only 6.3% for the strategy versus the benchmark at 9.5. So, it was actually very good in downmarkets. And then of course, my favourite green and blue chart here looks at how the model did in both upmarkets and downmarkets compared to the benchmark. In upmarkets it outperformed 63% of the time, whereas in downmarkets it outperformed 89% of the time. So, it's actually strong both in upmarkets and extremely strong in downmarkets.

So, all this goes to show even if you're looking at the unattractive areas of the market, the place that most people aren't looking, there still are good opportunities there that don't necessarily result in excessive risk.

From Morningstar. I'm Emily Halverson-Duncan.

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