Quant Concepts: Companies with cash on hand

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Emily Halverson-Duncan: Welcome to Quant Concepts virtual office edition. During periods of market volatility, such as what we've been experiencing this year, one thing investors are looking for are companies that can withstand this volatility without taking too big of a hit. While there are number of characteristics investors can look for, one of the most important to consider is the company's cash flow. Companies that have excess cash-on-hand will naturally be in a better position to continue making payments on any outstanding debt, maintain dividends paid out to shareholders, or even use that cash to grow the business through new projects and acquisitions.

Today's strategy searches for Canadian stocks which have excess cash available as well as a good history of growing their operating cash flow. So, let's take a look at how to build that. First off, as always, we're going to rank our universe of stocks. Our universe today holds 693 Canadian names within the CPMS universe. The factors that we're going to look at in today's model, first-off, annual cash flow momentum. So, that's looking at how much a company is growing their cash year-over-year and we want higher values for that. Five-year normalized cash flow growth is looking at the growth of a company's operating cash flow over a longer timeframe. So that's an annualized number, and again, we want to see that on the higher side. And then lastly, we look at both latest four quarters cash flow and latest four quarters free cash flow. So, difference here is the first being operating cash flow, so the cash that company is generating from their business activities, and free cash flow being that same metric, but less any capital expenditures, both of those, we would want to see higher values.

Once we've ranked our universe, we're going to go ahead and apply a few different screens. So, some of the screens we have here are that annual cash flow momentum, and the 5 year cash flow growth, we both – want to see positive values for those, so we want to see that they're actually growing their cash flow both in the short and long-term. The latest four quarters operating cash flow and latest four quarters free cash flow again, we want to see positive values. So, we just want to see that they're actually generating a positive values for those cash flow metrics.

And then lastly 5-year beta versus the TSX composite, this is a measure of market sensitivity. So, out of value of one, what that would indicate is the stock is as sensitive as the market, which in this case, we're using the S&P TSX composite. For this model, we want that to have a value of less than or equal to one, so to be as sensitive or less sensitive than the market.

On the sell side, so once we bought stocks, how do we know when to sell them? We've got four different sell triggers here. So, the four cash flow metrics that we looked at, again; annual cash flow momentum, 5-year cash flow growth, and then latest four quarters operating and free cash flow. We want – if those go, were to go below zero, we would sell that stock from the model.

But of course, we want to see how this model did across the long-term, so just jumping into the back-test results. We ran a 15-stock back-test from the period of September 2004 until March 2020. Returns across that timeframe were 15.3% annualized, which was an outperformance over the TSX of 9.5%. So, very strong posted numbers there. Turnover is about 54%. So again, turnovers looking at how often you're going to be trading from the model; 54%, that means you're trading just over half your portfolio on average in a given year. So that would be about seven or eight stocks, on average. We can see here as well. So, performance looks really good. But one thing I did want to focus in on is the year-to-date performance and looking to see and all this volatility that we have if companies that have excess cash have actually benefited. And we can see in 2020, the benchmark, that's the TSX returned minus 20.9%, whereas this strategy actually posted minus 16.5%. So, that's about little over 4%, about 4.5% difference and improvement for this strategy.

So when you're doing your own analysis on your own holdings, or different stocks that you're looking to buy, take a look and see what their cash flow position is, do they have a lot of cash on hand, do they not? And that may give you a good indication of how they'll withstand any market volatility. For Morningstar, I'm Emily Halverson-Duncan.