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Phil Dabo: Welcome to Quant Concepts' working from home edition. With so much uncertainty in the markets, it's even more important to keep a close eye on corporate fundamentals in order to maintain stability in your portfolio. The cash flow statement is one of the most important areas to check a business' fundamentals because cash is used to pay for corporate expenses, to manage debt, to distribute cash to shareholders, and to reinvest in profitable opportunities. Today, let's take a look at a strategy that has beaten the S&P 500 and focuses on companies with really good cash flow characteristics.
We're going to start by selecting our universe of stocks, which is the S&P 500 and from there we are going to rank these stocks from 1 to 500 according to six key factors. The first three factors focus on cash flow. We want stocks that have really strong quarterly and annual cash flow momentum. These are short-term metrics to identify companies that have been increasing their cash flow within the past year. The third factor is our three-year normalized cash flow growth to identify companies that have been able to grow their cash flow over a longer period of time. The next two factors will provide more downside protection. We want really strong cash flow in relation to debt. This will help us identify companies that have more liquidity and a stronger financial position to ride out a recession. The next factor is our 180-day standard deviation because we want stocks with lower fluctuation in price. The last factor is the market cap, and this will provide a bias toward larger-cap equities.
Now, let's take a look at our buy rules. We're only going to select stocks that are in the top 5th percentile of our list. And we're only going to buy stocks if their cash flow to debt ranks in the top two-thirds.
Our sell rules are very simple. We're going to sell stocks if they fall to the bottom half of our list, and we're going to sell stocks if their cash flow to debt deteriorates and falls to the bottom third of our list.
Now, let's take a look at the performance. The benchmark that we used is the S&P 500. And we ran the strategy from January 2006 to December 2020. Over that time period, the strategy generated an annualized return of 14.9%, which is 5.2% higher than the S&P 500, and only 54% annualized turnover. We can see by the annualized returns that this strategy has significantly outperformed the index over every significant time period, and it's done so with slightly higher market risk as measured by beta and slightly higher price risk as measured by standard deviation. However, it has produced superior risk-adjusted returns over time as measured by the Sharpe Ratio. We can see by this graph that the strategy has significantly outperformed over time and it's done so with a very strong market capture ratio, especially the upside capture ratio.
This is a great strategy to consider if you're looking to add stocks to your portfolio that have really good cash flow characteristics and if you're interested in a strategy that's tilted towards larger cap equities. With the possibility of more volatility coming within the next year, adding companies with really good cash flow momentum can help you navigate through difficult times.
You can find the buy list along with the transcript of this video.
From Morningstar, I'm Phil Dabo.
For a higher resolution image of the buy list, click here.
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