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Quant Concepts: Canadian stocks for volatile markets

Today we focus on downside protection to avoid any severe downward fluctuations in your portfolio 

Emily Halverson-Duncan 6 March, 2020 | 9:15AM
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Emily Halverson-Duncan: Welcome to Quant Concepts. Whether you are an avid investor or not, it's likely you've noticed the recent market sell-off across the globe. With so much uncertainty regarding the new COVID-19 coronavirus, some investors will take this as a signal to sell their holdings to cash to avoid further declines. One thing to remember during this volatility is that you only ever lose money when you sell at a loss. In other words, if your portfolio is down, but you choose to wait out the storm, you haven't actually lost any money.

Additionally, based on historical evidence, investors can undo the effects of a market downturn by staying invested over the long-term. This is certainly easier said than done, so taking the time to ensure your portfolio has a strong ability to manage market volatility will make staying invested an easier goal to achieve.

Today's strategy is searching for portfolio of Canadian stocks that are poised to weather volatile markets or they're focused on downside protection to avoid any severe downward fluctuations. So, let's take a look at how to build that.

First off, we're going rank our universe of stocks. Here, our universe is the 700 stocks in the CPMS Canadian universe.

For ranking, we're going to look at a few different factors, one of which is five-year price beta, so that looks at how sensitive a stock is compared to the market. In this case, the market is represented by the S&P TSX Composite, you want that to have a lower value.

Long Term Debt to Equity, starts looking at a company's debt to equity ratio. If it had a value of one, that means they have the same amount of debt as they do equity. So typically, you want that to be on the lower side. Total Price Return across – standard deviation across last five years; again, you want that to be a lower value. And lastly, Earnings Per Share Variability compared to the industry medium. So, again, that's looking at the earnings, how volatile they are, how big the deviation is, and then comparing that to the median of that stock's industry.

On the screening side, once we've ranked our universe, we're going to look at stocks with a five-year price beta, less than or equal to one. So, it's as sensitive as the market or less. Market cap in the top half of peers. So, today that has a value of 159 million or higher. Long Term Debt to Equity less than or equal to 1.1. So, again, to avoid having stocks with too much debt just a little bit more than they do equity. And Earnings Per Share Variability compared to the industry in the bottom half of peers, so that's 1.7 or below.

On the Sell Side. Well, sell stocks if their five-year price beta goes above 1.2 or if their long-term debt to equity goes above 1.3. And now, of course, we want to see how it did across the long-term and what the volatility looks like.

Here we're going to run a backtest of 15 stocks, the time period for the backtest is going to be January 2004 until February 2020.

All right, so across that time period, the annualized return was 11.2% compared to the benchmark, that's an overperformance of 4.1% annualized across that timeframe. Turnover is really low at 17%. Again, turnover is looking at how often you're trading in the model. So, 15 stocks, you'd be trading just under a fifth of them on average in a year.

Some of the metrics I always like to look at, especially for something that's supposed to be low vol. Downside deviation looks at the volatility of negative returns, so for the strategy that's 6.7%, for the benchmark is 8.6%. So, we can see that there is better downside protection on this model.

The other chart that I always like to look at is the green and blue chart here. It looks at how the model is done in both up and down markets and how often it has outperformed. So in up markets, it has only outperformed 36% of the time, so definitely not an upward momentum type of model. But in down markets, it has outperformed 86% of the time, so very, very strong in the down markets.

The other chart we can actually look at a little to the left here of this green and red chart shows the dispersion of returns. So, we can see here, for example, for returns greater than 10%, the model did more than 10% in three quarters compared to the benchmark at 6%. But more importantly, we can see a lot of the models' returns which are in maroon colour are between – about 5% and 10%, and between zero and minus 5%. So, keeping to not too high highs and not too low lows, you're keeping more in that centred space, which is why you can see such strong down market protection.

So, again, it's a little bit more volatile right now, might be worthwhile reviewing your portfolio and just make sure you are well prepared for any sort of market downturn.

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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