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Phil Dabo: Welcome to Quant Concepts' working from home edition. As demand for ESG investing grows, several key trends are emerging from climate change to social unrest. The coronavirus pandemic in particular has intensified discussions about how interconnected sustainability is with the financial system.
For those that don't know, ESG stands for environmental, social and governance. Investors are increasingly applying these factors as part of their process to identify material risk and growth opportunities. Some of these risks might include how corporations respond to climate change, how good they are with water management, how effective their health and safety policies are in protection against accidents, or how they manage their supply chains.
Today, let's take a look at a strategy that focuses on American companies that are less controversial. Let's start by selecting our universe of stocks, which is all of the American stocks in the CPMS database, and today that represents 2,000 stocks. We're going to rank our stocks from 1 to 2,000 according to six key factors.
The first factor is the ESG controversy level. Sustainalytics provides an assessment of controversies using news screens of over 60,000 sources. A news report if an issue is alleged or actual misconduct is assessed to determine stakeholder impact and reputation risk within 48 hours of the event. Lower scores are better. The next factor is the quarterly earnings momentum. Ideally, we would like to see companies that have recently increased their earnings per share. Our next factor is the quarterly earnings surprise. Because we would like to see companies that are growing their earnings per share and beating analysts' expectations at the same time. The next factor is the five-year beta. This will help us find stocks that have lower market risk compared to the S&P 500. The next factor is return on invested capital. This is a growth factor used to determine how efficient a company is at allocating its resources. Ideally, we would like to see companies that are using their capital to successfully generate profits. Our last factor is the price to earnings growth. We'd like to find companies that have really strong growth, but we also don't want to overpay per unit of growth.
Now, let's take a look at our buy rules. Our buy rules are very simple. We're only going to buy stocks that are in the top 15th percentile of our list. We are only going to buy stocks if their controversy level is zero. This strategy will predominantly focus on large cap stocks. Therefore, the buy list will be composed of stocks that are in the top third of our list based on the market cap. Today, that represents approximately 9 billion. Our last buy rule is the Morningstar Quantitative Health Score. This is a proprietary measure that ranks companies on the likelihood that they will tumble into financial distress. We don't want stocks that are in the top third of our list based on the Quant Health Score.
Now, let's take a look at our sell rules. Our sell rules are very straightforward. We're going to sell stocks that fall out of the top 35th percentile of our list. We are going to sell stocks if their controversy level goes above zero, and we're going to sell stocks if their financial health deteriorates and falls to the bottom third of our list based on the Morningstar Quantitative Financial Health Score.
Now, let's take a look at performance. The benchmark that we used is the S&P 500 Total Return Index, and we tested this strategy from January 2010 until January 2021. Over this time period, this strategy has generated an outstanding 20.1% return, which is 5.8% higher than the S&P 500 and it comes with a 68% annualized turnover. We can see that this is a strategy that has beaten the index over every significant time period, and it's done so with slightly lower market risk as measured by beta.
This strategy does have slightly higher price risk as measured by the standard deviation; however, it has (indiscernible) as measured by the Sharpe Ratio. We can see that this is a strategy that has outperformed the S&P 500 over the past 10 years, and when looking at the market capture ratios, we can see that this is a strategy that does well in both up and down markets.
This is a great strategy if you're looking for companies that are less controversial and for those that are looking for companies that have sound ESG fundamentals. It's also a great strategy for investors that are looking for higher-quality companies that have growth characteristics as well. You can find the buy list along with the transcript of this video.
From Morningstar, I'm Phil Dabo.
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