Quant Concepts: Downside Defense

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Phil Dabo: Welcome to Quant Concepts working from home edition. As we continue to see the S&P 500 reach new highs, some investors are becoming more interested in buying stocks that will provide more downside protection so that they can preserve the gains that they've made over the past 10 years.

The consumer defensive sector is a great place to look for stocks that do well when the stock market doesn't, because they're typically non-cyclical. And these companies usually have products that are always on demand, regardless of whether or not the economy is doing well. We also want to make sure that these companies have a sufficient amount of cash on hand during difficult times, such as COVID pandemic, so that they can adapt to unexpected circumstances.

Today, let's take a look at a strategy that focuses on American companies in consumer defensive sectors that have strong cash flow. Now let's take a look at our strategy. We're going to start by selecting our universe of stocks, which includes all 2,000 stocks in our U.S. database. Next, we're going to rank those stocks from one to 2,000 according to five key factors.

The first factor is our quarterly earnings surprise because we would like to see companies consistently beat analyst expectations for quarterly earnings. Next, we have our market capitalization to implement a bias toward larger cap equities. Our next three factors relate to cash flow. We have the quarterly cash flow momentum, the annual cash flow momentum, and the three-year normalised cash flow growth. Now that we have our stocks ranked, we're going to go through the screening process. It's important to note that we've screened out every single sector except for consumer defensives, the health care sector and the utility sector. We're only going to buy stocks that are ranked in the top 15th percentile of our list.

This strategy is not going to exclude stocks from the buy list if their quarterly cash flow momentum and annual cash flow momentum go below 0%. But they can't be below 0% at the same time. We're only going to buy stocks if the three-year cash flow momentum is above 0%. We want to limit the market capitalization of stocks that are below $1 billion so that we eliminate microcap stocks. We want to limit the amount of market risk in the portfolio. So we've limited the beta to 1.3. Lastly, we're only going to buy stocks that are ranked in the top third, based on the price change to 12-month high and the 180-day standard deviation. The price change to 12-month high is a good momentum variable that provides good downside protection, as some stocks that are trading close to their previous 12-month high have tended to perform well.

Now let's take a look at our sell rules. We're going to sell stocks if they fall out of the top 40th percentile of our list. We're also going to sell stocks if the quarterly cash flow momentum, annual cash flow momentum and three-year cash flow growth are all negative at the same time. Lastly, we're going to sell stocks if their beta goes above 1.3. Now let's take a look at performance. The benchmark that we use is the S&P 500 Total Return Index. And we tested the strategy from January 2006 to August 2021. over this time period, this strategy generated a very strong 14.3% return which is 3.6% higher than the benchmark and only a 43% annualised turnover.

We can see by looking at the annualised returns, that the strategy underperformed the benchmark over the one, three, and five-year periods, but outperformed the benchmark over longer periods of time such as the 10 and 15-year. It's also important to note that when looking at the calendar year returns, the strategy generated a negative 9.8% return during the 2008 crisis. Whereas the benchmark generated a negative 37% return. If we look at the past 10 years, the strategy hasn't had a single negative year return. And the worst calendar year was 3.3% versus the benchmark, which was negative 4.4%. So we can see that this strategy has generated really good downside protection, as you can see by the standard deviation, which has contributed to superior risk adjusted returns, as you can see by the Sharpe ratio, where the strategy outperforms the benchmark over every significant time period. And it's not surprising that this strategy has lower market risk, as you can see by beta.

When looking at this performance chart, we can see really good outperformance by the strategy over time. And when looking at the up and downside capture ratios, we can see that the strategy has really good downside performance, outperforming the benchmark most of the time while still participating in up markets. When we bring these two together, we can see a very good overall market capture ratio that comes from the fact that the strategy outperforms when the market is going down. This is a great strategy to consider if you're looking for companies that are in the consumer defensive sector 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 provided really good downside protection without sacrificing returns. You can find the buy list along with a transcript of this video.

From Morningstar I'm Phil Dabo.

Find the buy list here.