Quant Concepts: Sales Growth with Earnings Momentum

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Phil Dabo: Welcome to Quant Concepts' working from home edition. As we move through the pandemic, we've seen some companies that are able to grow their top-line revenue much better than others. However, it's also very important to determine how revenue gets translated into the growth of a company. Typically, companies are growing when they can generate significantly higher revenues with lower costs. This will not only contribute to the profitability of the company, but it's also important for companies to convert their income into cash that they can then use to pay for expenses and to reinvest in business opportunities.

Today, let's take a look at a strategy that has good sales growth as well as cash flow and earnings momentum. We're going to start by selecting our universe of stocks. In this case, I've selected all of the Canadian stocks in our CPMS database and have also tried to eliminate natural resource stocks.

Next, we're going to rank our stocks according to seven key factors. The first two factors are five-year normalized sales growth and our annual sales momentum. This will help us identify stocks with good long-term and short-term sales numbers. The next factor is our cash conversion cycle. This will help us identify companies that are successful at turning their inventory of goods into cash flow from sales.

The next two factors are quarterly cash flow momentum and our quarterly earnings momentum. Ideally, we would like to see companies that are successful at growing their bottom-line while also turning profit into cash. The next factor is our market float, and this is going to help us have a bias toward large-cap equities. The last factor is our return on equity, which is a common measure of financial performance that calculates the profitability of a company in relation to shareholder equity.

Now, let's take a look at our buy rules. We're only going to buy stocks that rank in the top 30th percentile of our list. We're only going to buy stocks that are ranked in the top two-thirds of our list based on the cash conversion cycle. We've placed a limit on the market cap of $470 million in order to eliminate microcap stocks. We've also placed a limit on ROE of 10, so that we can get companies with stronger growth numbers. We've also attempted to reduce the amount of price volatility in this strategy by eliminating stocks that have a standard deviation that is greater than two-thirds of our list. We've also included a limit on the price change to a 12-month high, because buying stocks that are trading close to their previous 12-month high tend to continue doing well. Our last buy rule is a working capital ratio. This is a very important liquidity ratio, especially for companies that have inventory because it's calculated as current assets divided by current liabilities.

Now, let's take a look at our sell rules. We're only going to sell stocks if they deteriorate and drop to the bottom half of our list. We're only going to sell stocks if their working capital ratio deteriorates and again falls to the bottom third of our list. And lastly, we're going to sell stocks if it takes longer for the company to convert sales to cash and their cash conversion cycle falls out of the top two-thirds of our list.

Now, let's take a look at performance. The benchmark that we've used is the S&P/TSX Total Return Index, and we tested the strategy from January 2005 to February 2021. Over this time period, this strategy has generated a very strong 12.8% return, which is 5.5% higher than the index, with only 29% annualized turnover. We can see by looking at the annualized returns that this is a strategy that has outperformed the benchmark over every significant time period, and it's done so with a very strong one-year return of 31.4%. We can see that this is a strategy that has lower price volatility as we can see by the standard deviation, with also higher risk-adjusted returns as measured by the Sharpe Ratio with lower market risk as you can see by beta.

When looking at this chart, we can see that this is a strategy that has performed well over time and particularly over the past year. When looking at the market capture ratios, we can see that this is a strategy that can perform well throughout different market cycles and particularly outperforms in down markets. This is a great strategy to consider if you're looking for companies that are less focused on the natural resource sector and that have good sales growth. Some of these ideas provide a great way to diversify your portfolio with smaller companies such as Leon's Furniture as well as larger companies such as Magna International. Many of the companies on the buy list are also in the consumer goods sector, which makes up less than 10% of the S&P/TSX. You can find the buy list that includes some of these companies with good sales growth along with the transcript of this video.

From Morningstar, I'm Phil Dabo.