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Quant Concepts: Quality Growth

With the volatile start to the year, consider this strategy that focuses on durable, compounding earnings.

Joshua Farruggio 14 January, 2022 | 8:21AM
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Joshua Farruggio: Welcome to Quant Concepts' working from home edition. As investors forecast a March rate hike from the U.S. Federal Reserve, equity markets have started the year in a volatile fashion. Long-duration equities have been put under pressure with the U.S. 10-year Treasury yield trending toward 2%. When monetary policy tightens, growth investors looking to weather inflation should see quality companies with steady earnings.

Today, let's take a look at a strategy that identifies credible growth potential with companies that have a high reinvestment rate and strong earnings momentum.

Let's start by selecting our universe of stocks which includes all 2,000 companies in our U.S. database. Next, we are going to rank our stocks from 1 to 2,000 using five key factors. The first two factors are the reinvestment rate using next year's median EPS and the current year median EPS, both measuring the rate at which a company is expected to reinvest earnings back into its business and is a common measure of the growth of a company. The third and fourth factors are based on EPS growth. We will look at next year's change in EPS growth and the average normalized earnings growth from the past three years. Price momentum will be the final factor as we look for companies that had positive price change in the last three months.

Now that we have our 2,000 stocks ranked, let's apply our buy rules. We are going to buy stocks in the top 20th percentile of our list. After that, we are going to look at the price change of the last three months and make sure that any stock that we buy is positive. Let's apply our Morningstar Quant Financial Health Score as well where this measures the likelihood that a company will tumble into financial distress. We want stocks in the top third for this variable.

After that, we are going to purchase companies that have an annual earnings momentum greater than 10%. It's a proprietary variable that measures the rate of change of annual operating earnings. Next, we are going to make sure that we have five analysts covering each stock. Followed by that, we'll take a look at liquidity to make sure that we have an average daily value traded of above 37 million in the last three months. Finally, let's take a look at market cap and make sure that we remove any small cap stocks by putting a greater than of 2.6 billion.

Now, let's look at our sell rules. We are going to sell stocks if they deteriorate and fall out of the top 40th percentile. We are also going to sell stocks if our Morningstar Quantitative Financial Health Score falls below 0.52 and our annual earnings momentum falls below 0.

Let's look at performance. The benchmark that we used is the S&P 1500 Pure Growth Index, and we tested this strategy from January 2006 to December 2021. Over this time period, the strategy generated a very strong 17.7% return, which is 6.5% higher than the benchmark and only a 24% annualized turnover. We can see by looking at the annualized periods, this strategy has performed better than the benchmark over every significant time period. The strategy offers lower price risk, as you can see by standard deviation, downside deviation also being 2% lower than the benchmark, and we also have superior risk-adjusted returns with a Sharpe Ratio doubling the index. In addition, you can see a beta of 0.8 displaying lower market risk.

Looking at the green and blue charts below, the strategy has performed well in both up and down markets, adapting in various cycles. This is a great strategy to consider if you are looking for quality growth stocks that present durable compounding earnings. With low market risk and good upside, the model has outperformed the index 13 of the past 16 calendar years. You can find the buy list along with the transcript of this video.

From Morningstar, I'm Josh Farruggio.

The buy list is available here.

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Joshua Farruggio  Vice President, Business Development, CPMS

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