Quant Concepts: Great GARP

By combining attributes of both growth and value stocks, Phil Dabo finds a deal on outperformance. 

Phil Dabo 4 October, 2021 | 10:03AM
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Phil Dabo: Welcome to Quant Concepts' working from home edition. There have been a lot of comparisons between the growth and value styles of investment management. Some investors prefer to focus on capital appreciation by investing in growth-oriented businesses such as those in the tech sector. Many of these companies will look more expensive when looking at metrics such as the price to earnings. Other investors prefer to invest in companies that are trading well below their intrinsic value with lower metrics such as the price to book. We can also employ a strategy that's based on growth at a reasonable price which combines attributes of both growth and value investing. Today, let's take a look at a strategy that focuses on identifying companies that have higher growth and still trade at reasonable prices.

We are going to start by selecting our universe of stocks, which includes all 700 companies in our Canadian database. Next, we are going to rank our stocks according to nine key factors. The first factor is our forward reinvestment rate to find companies that are expected to invest in growth opportunities. The next factor is our forward quarterly earnings momentum to capture companies that are expected to grow their earnings. We also want companies that consistently report good earnings numbers, so we are going to reduce the variability of historic EPS. We are also going to reduce volatility with the 180-day standard deviation so that there is lower price risk.

Our next two factors are to get companies that have lower valuations based on the price to earnings and the price to book. Our last three factors are to capture companies with higher earnings momentum. We want companies that have positive quarterly earnings momentum where analysts continue to have a positive expectation for, and we want the company to consistently beat those expectations.

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 20th percentile of our list. We are only going to buy stocks that have a forward reinvestment rate that is greater than the average for all of our stocks and if the forecasted earnings momentum is greater than negative 3%. We want to eliminate stocks from our buy list that have a historic variability of earnings per share that is ranked in the bottom third of our list and if the quarterly earnings momentum is below negative 1%. We also want to eliminate most small-cap stocks. So, we've placed a limit on the market cap of approximately $1.4 billion and we've reduced the amount of market risk by limiting beta to 1.5.

Now, let's take a look at our sell rules, which are quite simple. We are going to sell stocks if they deteriorate and fall out of the top 30th percentile. And we are also going to sell stocks if their quarterly earnings momentum drops below negative 5%. We've reduced the amount of market risk by limiting beta to 1.5.

Now, let's take a look at performance. The benchmark that we used is the S&P/TSX Total Return Index, and we tested this strategy from January 2006 to August 2021. Over this time period, the strategy generated a very strong 15.6% return, which is 9% higher than the benchmark and only a 46% annualized turnover. We can see by looking at the annualized periods that this strategy has performed better than the benchmark over every significant time period. Even though it adds slightly higher price risk as you can see by the standard deviation, the strategy has generated superior risk-adjusted returns as you can see by the Sharpe Ratio. It's no surprise here that this strategy comes with lower market risk as you can see by beta.

When looking at this performance chart, you can see very good outperformance over time. And when looking at the up and downside capture ratios, you can see that this is a strategy that has performed well throughout different market cycles and has performed really well in down markets. This is a great strategy to consider if you are looking for companies that are more growth-oriented, but you don't want to pay excessively for owning the stock. As the performance tables showed, this strategy generally has less market risk, which has resulted in only two negative calendar years over the past 15 years. The buy list also has a lot of good diversity from companies of all different sizes and sectors. You can find the buy list along with the transcript of this video.

From Morningstar, I'm Phil Dabo.

Find the buy list here.

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Phil Dabo  Phil Dabo is Director, CPMS Sales

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