Quant Concepts: A Strategy for Energy Volatility

Learn how Phil Dabo's energy price momentum strategy outperforms, especially on the downside.

Phil Dabo 3 December, 2021 | 4:48AM
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Phil Dabo: Welcome to Quant Concepts. We've seen a lot of volatility over the past week with the Cboe Volatility Index up 40% since last Tuesday. A large part of this is due to the uncertainty surrounding the Omicron variant, which the World Health Organization declared a variant of concern. Since then, the energy sector experienced even more volatility with the WTI oil price plunging from $78 to a low of $65 per barrel. Some stocks within the energy sector had already experienced a significant amount of price appreciation over the past six months as the WTI price was up almost 80% since the beginning of the year.

Today, let's take a look at a strategy that focuses on price momentum within the energy sector, and it might help you identify some companies to buy during temporary market weakness.

As always, let's start by selecting our universe of stocks, which includes all 102 energy companies in our Canadian database. Next, we are going to rank our stocks according to five key factors. The first three factors relate to price momentum based on the three, six and nine-month time periods. I included the Morningstar quantitative financial health score to make it a bit easier to determine if a company is in good financial health. We use a proprietary methodology to determine the likelihood that a company will fall into financial distress by measuring the firm's distance to default. Our last factor is the market cap, because I'd like to put a small bias toward larger-cap equities.

Now that we have our stocks ranked from 1 to 100, we are going to go through our screening process, starting with our buy rules. We are only going to buy stocks that are ranked in the top 30th percentile of our list, and I used the price change to 12-month high because companies that have traded close to their previous 12-month high have tended to perform well. This is a momentum metric that has really good up and downside capture ratios. I placed the limit on the Morningstar quantitative financial health score so that we eliminate companies that are ranked in the bottom third. The last buy rule is the market index price versus the 80-day moving average. Placing a limit of 0 on this metric will move the model into cash if we are going through a severe bear market. I included this rule because I'm trying to capture a lot of upside without the downside in the market.

Now, let's take a look at our sell rules, which are very simple. We are going to sell stocks if they fall out of the top half of our list, and if the financial health deteriorates and falls to the bottom of our list. We are also going to move the model into cash if the market price versus its 80-day moving average goes below 0, so that we reduce the amount of downside risk in the portfolio.

Now, let's take a look at performance. The benchmark that we used is the S&P/TSX Energy Total Return Index, and we tested this strategy from January 2006 to October 2021. Over this time period, the strategy generated a very strong 18.7% return, which is 18% higher than the benchmark with a quite high 189% annualized turnover. We can see by looking at the annualized returns that this is a strategy that has significantly outperformed the benchmark over every significant time period, and it's done so with higher price risk as you can see by the standard deviation. That being said, the strategy does have significantly less downside risk, as you can see by the downside deviation. The strategy also has significantly higher risk-adjusted returns as you can see by the Sharpe Ratio and much less market risk as you can see by beta.

When looking at this performance chart, you can see very good outperformance over time, and there are also periods of time when the performance line is flat because this strategy is holding cash. When looking at the up and downside capture ratios, we can see that this is a strategy that performs very well in down markets but still participates very nicely in up markets where the overall market capture ratio is quite high, showing that this is a strategy that has performed well throughout different market cycles.

This is a great strategy to consider if you are interested in stocks that are in the energy sector that still have good price momentum. A lot of companies on the buy list have already been up by more than 100% this year, but there might still be a lot of room for growth if you believe that energy prices will trade between $80 to $100 per barrel over the next year. You can find the buy list along with the transcript of this video.

From Morningstar, I'm Phil Dabo.

The buy list is available here.

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Phil Dabo  Phil Dabo is Director, CPMS Sales

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