Quant Concepts: Taking a Break?

CPMS's Emily Halverson-Duncan tests what can happen when you go cash in downmarkets, and finds some surprising outperformance

Emily Halverson-Duncan 25 September, 2020 | 1:18AM
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Emily Halverson-Duncan: Welcome to Quant Concepts, virtual office edition. With markets continuing to show turbulence throughout 2020, its understandable investors may be concerned about their portfolio. Volatility can make even the most seasoned investor question their methods. The typical advice in any period of volatility is to stay invested, and for good reason. But going to cash could be a tempting option to avoid downward fluctuations. What's most important, however, is whatever method you choose to follow is based on research rather than emotion. Today I'm going to showcase a strategy that will be looking for the top dividend growing stocks, but will only be invested so long as the markets trending above its 80 day moving average. So let's take a look at how to do this.

First off, as always, we're going to go through and rank our universe of stocks. Our universe here is our CPMS Canadian universe, which holds 695 names. In this first step, it's a very, very simple ranking screen. We're only looking at stocks that have a high expected dividend growth, So what that's looking at is comparing their trailing four quarters dividends to what they're expected to pay out across the next four quarters, and we want to see a higher value there, indicating that they're growing their dividends across the next year.

On the screening side, we've got a few screens in place here. I'm going to come back to this top one, but just to touch on the below screens, we want to have a market cap that's in the top roughly half of peers, and today it has a value of just shy of $400 million or higher. We want to have a positive expected dividend growth, meaning they are actually growing their dividends. And lastly, we want them to have paid a dividend in the last four quarters. Meaning we don't want a company that wasn't paying a dividend and then just started. Coming back to that top screen here, this is kind of the key part of this model. What this is looking at is the market index compared to its 80-day moving average, and we want that to be positive.

So in other words we want to see the market trending upward for us to be invested in those dividend growth stocks. On the flip, if it's below that level, so if the market is trending downward compared to its 80-day moving average, we're actually going to be invested in cash instead, and the hopes there is that we're moving to cash when there's periods of volatility, but we're catching it before the market goes down too far. So ideally we can avoid those extreme negative fluctuations. The other thing that we would sell on is if a company that we were holding were to cut their dividends that would be a sign for us to again get rid of that stock.

So let's take a look at how this did across our backtest. This backtest is going to look a little bit different than what it usually would look like, because we're going to be going into cash and out of cash depending on that technical indicator that we looked at.

So we can see across this time frame we invested from September 1997 to August 2020. There were 15 stocks that were purchased and the return there was 12.7%, which is an outperformance of the benchmark the S&P/TSX of 6.3%, so really good outperformance that we can see there. But a couple of things I want to guide your attention to. If we look at the graph here, we can see that there's periods where the line, the red line here of our model is just straight. What that indicates is that's a period where we were just in cash, meaning that the market had trended downward. We moved entirely to cash and then waited until it started trending upward to go back in again. So a bit of a different type of a portfolio here than what we usually see.

But the impacts quite positive in terms of downside protection. If we look at our downside deviation, which is the volatility of negative returns, the strategy has a downside deviation of 5% versus the benchmark of 10.8%, so less than half. And then of course this green and blue chart here the model outperformed in 42% of up markets, but outperformed in 75% of down markets. So about three quarters of the time it's outperforming the benchmark when TSX is declining.

One other quick stat that I wanted to look at here is the max drawdown. So what max drawdown looks at is the period that the strategy and the benchmark had their lowest returns before starting to recover. So for the strategy that's negative 10.1% and then the benchmark however is negative 43.4%. So again, you can see in terms of their absolute worst drawdown, the strategy is better by about a factor of a fourth. So pretty significant improvement there that we can see in terms of downside protection. So again a bit different of a way to handle volatility and does require a pretty active approach. So for anything like this, it's definitely best to talk to an investment professional.

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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