Quant Concepts: Strong U.S. Balance Sheets

A balance sheet is a great source of information regarding a company's financial health

Emily Halverson-Duncan 4 December, 2020 | 1:35AM
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Emily Halverson-Duncan:
Welcome to Quant Concepts' virtual office edition. Last week, we explored the value of using a Canadian company's balance sheet to determine whether or not that company was a good buy. Recall that the balance sheet is a great source of information regarding a company's financial health. Equity analysts will often derive a number of different ratios from the statement to get a clear picture as to what recommendation they should offer upon a particular stock.

Today's strategy is going to look for companies with strong balance sheet in the CPMS U.S. universe and see how that model would have done over time. So, let's take a look at how to build that.

Jumping into CPMS, as I mentioned, our universe is going to be the full CPMS U.S. universe, which today holds 2,069 stocks. We're going to organize that universe in our first step, and some of the factors we're going to look at here – latest cash flow to debt, which looks at how much cash flow a company has per unit of debt on their books, and we want that to be a higher value. Debt to equity controls how much debt they have on their books, and on this case, we want it to be lower, so lower amount of debt per unit of equity. Trailing ROE is a measure of profitability, so we want to have higher values there. And then, lastly, five-year beta versus the S&P 500 index is a measure of a company's sensitivity relative to the index and we want to see lower values there.

On the screening side, once we've organized our universe, we're going to look for companies with a cash flow to debt in the top half of peers, which today has a value of 0.25 or higher. Long-term debt to equity capped at 1.1, so just making sure their debt isn't too high compared to equity. Latest debt to total assets, it's another way of measuring debt and we want that to be in the lower half of peers. In this case, that has a value of 0.38 or below. A market cap, we're putting in the top half of peers, which today has a value of about 1.8 billion or higher and that's just to remove any small cap illiquid names. That trailing ROE that we talked about, we want that to be in the top third of peers, which day has a value of about 15.7% or higher. And then, lastly, that five-year beta as well, we want that to have a value no more than 1.3, so 1.3 or lower to make sure the sensitivity isn't too much higher than that of the market.

On the sell side, we're going to go ahead and sell socks if their cash flow to debt falls below the bottom third of peers, which today has a value of 0.12 or below, or if their long-term debt to equity rises above 1.3.

Once all those screens are applied, we can go ahead and take a look at how the back test of the strategy did. Looking at our back test here, we ran a back test from April 2004 until October 2020 with 15 stocks that were selected. The benchmark we're comparing to is the S&P 500. Across this timeframe the model returned 13.4% annualized, which is an outperformance of 4.4% over the benchmark. Turnover was very low at 14% and again, turnover is looking at how often you are trading stocks from the model. So, at 14% on a 15-stock model, you're looking at a few trades a year on average.

A couple of the other metrics that I always like to look at – downside deviation, which is the volatility of negative returns for the strategy was 9.4% and for the benchmark was 9.8%. So, pretty similar in terms of downside deviation. And then, how did the model do in both up and down markets? In up markets, the model outperformed 54% of the time compared to the benchmark and in down markets, outperformed 71% of the time. So, pretty clear downside protection as compared to the benchmark.

So, for yourself, as you're analyzing companies and trying to figure out what a good buy is, don't forget that the balance sheet holds a whole wealth of information you can use in making your analysis.

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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