Quant Concepts: Small-Cap and Mid-Cap Success

CPMS's Phil Dabo finds a strategy with very strong performance over time that can also add diversification to portfolios

Phil Dabo 28 May, 2021 | 4:28AM
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Phil Dabo: Welcome to Quant Concepts' working from home edition. Small cap stocks have done fairly well recently with the S&P Small Cap Total Return Index generating a 13% return last year and a 14% return year-to-date, which is better than the broader S&P/TSX Total Return Index. Although small cap stocks might be too volatile for some investors and lack the liquidity for others, they can provide meaningful diversification benefits to your portfolio.

Today, let's take a look at a very interesting strategy that combines two models with a focus on small and midcap stocks that can generate less volatility.

The first model that we have will use all 700 stocks in our Canadian database, and then we are going to rank those stocks based on the five-year normal earnings per share growth rate, the five-year average return on equity, the five-year standard deviation of price, the five-year deviation around earnings per share, and lastly, beta.

Now, let's take a look at the buy rules for our first model. We are going to buy stocks that rank in the top 25th percentile of our list, and we are only going to buy stocks that have a market float above $70 million but below $1 billion. The five-year deviation of earnings per share must be in the top third of our list. We also want positive values for the average ROE over the past five years, the trailing ROE, the five-year normal earnings per share growth rate, the quarterly earnings momentum, the three-month price change and the adjusted book value.

Now, let's take a look at the sell rules for our first model. We are going to sell stocks that drop out of the top 35th percentile of our list. We are also going to sell stocks if they have a negative value for the five-year average ROE, the trailing ROE and the five-year normal earnings per share growth rate. We are also going to sell stocks if their quarterly earnings momentum drops below negative 5%.

Now that we have our buy and sell rules to identify small cap companies that are more stable, we are going to combine them with our buy and sell rules and identify value-oriented small and midcap stocks. To identify value-oriented small and midcap stocks, we are going to rank our stocks from 1 to 700 according to the price to trailing earnings, the price to trailing cash flow, beta and the quarterly free cash flow momentum.

Now, let's take a look at the buy rules for our second model. We are only going to buy stocks that are in the top 10th percentile of our list, and the stocks have to have a beta of less than 2, a market cap that is less than $12 billion, an industry relative debt to equity in the top two-thirds of our list, a trailing return on equity in the top third of our list and a price change to 12-month high in the top third of our list because companies trading close to their 12-month high have performed well.

Now, let's take a look at the sell rules for our second model. We are only going to sell stocks that fall out of the top 20th percentile of our list.

Now that we've put a 50% weight to each of the two models, let's take a look at performance. The benchmark that we used is the S&P/TSX SmallCap Total Return Index, and we tested this strategy from January 2004 to April 2021. Over this time period, this strategy has generated a very strong 20.4% return, which is 16.2% higher than the index with only a 48% annualized turnover. We can see that this is a strategy that has outperformed the benchmark over every significant time period, and it's done so with significantly less price risk as you can see by the standard deviation. This contributes very nicely to superior risk-adjusted returns as you can see by the Sharpe Ratio, and you can also see that this is a strategy that has generated very good alpha with less market risk as you can see by beta.

When looking at this graph, you can see very strong performance over time, especially over the past year. And when looking at the up and downside capture, you can see that this is a strategy that has performed well over different market cycles which contributes very nicely to an overall market capture ratio. This is a great strategy to consider if you are interested in small and midcap stocks that can add alpha to your portfolio. Over the past 15 years, this strategy has only produced negative calendar year returns in 2018 and 2008. In addition to really strong historical performance, some of the names on the buy list can provide exposure to less well-known stocks that can add diversification to your portfolio. You can find the buy lists along with the transcript of this video.

From Morningstar, I'm Phil Dabo.

Small and Mid Cap Value

Small and Mid Cap Value

 

For a larger image of the buy list, click here.

 

Steadier Small Caps

Buy list

For a larger image of the buy list, click here.

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Phil Dabo  Phil Dabo is Director, CPMS Sales

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