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Phil Dabo: Welcome to Quant Concepts' working from home edition. Having a sufficient amount of cash on hand is important for a business in order to pay for ongoing operations. It was particularly important throughout the COVID pandemic, as many businesses came under pressure and needed to adapt to unexpected circumstances. Now that the economy is doing better, we would also expect that companies are reporting stronger earnings.
Today, let's take a look at a strategy that focuses on American companies that have strong cash flow and that have beaten analyst expectations for quarterly earnings. 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 five key factors.
The first factor is our quarterly earnings surprise, because we'd like to see companies consistently beating analyst expectations for quarterly earnings. Next, we have our market cap to implement a bias toward larger cap equities. The next three factors relate to cash flow. We have the quarterly cash flow momentum, annual cash flow momentum and the three-year normalized cash flow growth.
Now that we have our stocks ranked, we are going to go through the buy rules. We are only going to buy stocks that are ranked in the top 10th percentile of our list. The strategy will not exclude stocks from the buy list if their quarterly and annual cash flow momentum are below 0% as long as they are not below 0% at the same time. However, we are going to buy stocks only if their three-year normalized cash flow growth is above 0%. The market cap of the companies must be above 1.1 billion so that we eliminate microcap stocks. We also want to limit the amount of market risk into the portfolio. So, we have limited the beta to 1.3. Lastly, we are going to buy stocks that are ranked in the top third based on the price change to 12-month high. This is a good momentum variable that provides good downside protection as stocks trading close to their 12-month high have historically done well.
Now, let's take a look at our sell rules. We are going to sell stocks if they fall out of the top 50th percentile of our list. We are also going to sell stocks if their quarterly and annual cash flow momentum are below 0 and the three-year normalized cash flow growth are all below 0% at the same time. Lastly, we are going to sell stocks if the beta goes above 1.3.
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 2006 to April 2021. Over this time period, this strategy has generated a very strong 14.3% return, which is 4% higher than the S&P 500 with only a 48% annualized turnover. When looking at the annualized performance, we can see that the strategy has outperformed the index over every significant time period. However, it has done that with slightly higher price risk, as you can see by the standard deviation. Although the standard deviation is slightly higher, this strategy has still achieved strong risk-adjusted returns as you can see by the Sharpe Ratio with slightly lower market risk as you can see by beta.
When looking at the performance chart, we can see really good performance over time, especially over the past year and when looking at the market capture ratios, we can see that the strategy has performed well in both up and down markets, which has contributed to a very nice overall market capture ratio showing that this strategy has performed well throughout different market cycles. This is a great strategy to consider if you are looking for companies that have had strong earnings surprises and have good cash flow momentum. As you saw from the performance chart, companies that exhibit these characteristics that were purchased into the strategy have had excellent performance throughout the past year as we navigated through the pandemic. You can find the buy list along with the transcript of this video.
From Morningstar I'm Phil Dabo.
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