Quant Concepts: ESG Cash Flow

Phil Dabo finds 10 years of outperformance in a cash-flow-focused strategy that leverages the power of responsible investing.

Phil Dabo 7 May, 2021 | 4:38AM
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Phil Dabo: Welcome to Quant Concepts' working from home edition. Research increasingly shows that investing in ESG can reduce portfolio risk, generate competitive investment returns, and helps investors feel good about what they own.

The COVID-19 pandemic has only strengthened the case for ESG investing because evidence has shown that companies that rank highly on ESG issues tend to be less volatile. Net assets into ESG mutual funds and ETFs in 2020 increased by approximately 37% from the year before, showing that investors are becoming increasingly interested in it.

Today, let's take a look at a strategy that focuses on companies that have good cash flow and good ESG characteristics. We are going to start by selecting our universe of stocks which includes all 2,000 stocks in our U.S. database. We are going to rank those stocks from 1 to 2,000 according to six key factors.

The first factor is the ESG controversy factor, which is an assessment by Sustainalytics of controversies using over 35,000 new screens. The next factor is beta, because we'd like to reduce market risk. The next factor is the price change to 12-month high, which is a momentum factor that I really like because buying certain stocks that are trading close to their previous 12-month high tend to do well. And the last three factors are quarterly cash flow momentum, our annual cash flow momentum, and our three-year normalized cash flow growth.

Now, let's take a look at our buy rules. We are only going to buy stocks that are ranked in the top 10th percentile of our list. We are only going to buy stocks with the market cap above 1.6 billion, which pretty much eliminates most small cap stocks. The ROE needs to be at least 10%, which generally shows decent financial performance. The stock needs to have a positive value for the quarterly cash flow momentum, the annual cash flow momentum and the three-year normalized cash flow growth. The stock also needs to have a cash flow to debt that ranks in the top third of our list. This will attempt to exclude companies that are taking on excessive amounts of debt without generating significant cash flow.

We also don't want companies that have excessive amounts of debt in relation to equity. So, we are only going to buy companies that have a debt to equity in the top two-thirds of our list. Lastly, in an attempt to reduce the amount of market risk in the portfolio, I've put a limit of 1.5 on beta.

The sell rules are very simple. We are only going to sell stocks if they fall out of the top half of our list, and we are going to sell stocks if the cash flow to debt deteriorates and falls to the bottom third of our list. Now, the last sell rule is very interesting. The process will recommend selling stocks based on the quarterly cash flow momentum, annual cash flow momentum and three-year normalized cash flow growth. It's okay for a stock to have a negative value for any one of these variables, but the model will recommend selling stocks if all three variables are negative at the same time.

Now, let's take a look at performance. The benchmark that we've used is the S&P 500 Total Return Index. And we tested this strategy from January 2010 to March 2021. Over that time period, this strategy has generated a very strong 19.9% return, which is 5.1% higher than the benchmark with only a 38% annualized turnover. When looking at the annualized returns, we can see 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 69.2%, which shows really good outperformance coming out of the lows that we experienced at the beginning of last year. Now, this strategy has slightly higher price volatility, as you can see by the standard deviation and market like risk as you can see by the beta, but it also has really good risk-adjusted returns as you can see by the Sharpe Ratio.

I really like to look at this chart because it shows really good outperformance of the strategy over the past 10 years and really good market capture ratios as you can see that this is a strategy that has performed well in both up and down markets which contributes very nicely to an overall market capture ratio.

This is a great strategy to consider if you are looking for mid and large cap companies that are less controversial with good cash flow momentum. Over half of the buy list is made up of tech companies, and most of them are not included in the S&P 500. This can provide great diversification benefits for portfolios that have more exposure to the S&P 500. You can find the buy list along with a transcript of this video.

From Morningstar, I'm Phil Dabo.

Buy list

For a higher resolution image of the buy list, click here. 

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Phil Dabo  Phil Dabo is Director, CPMS Sales

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