Quant Concepts: Going Value?

Phil Dabo builds a portfolio that's performed well throughout various market cycles.

Phil Dabo 4 February, 2022 | 4:29AM
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Phil Dabo: Welcome to Quant Concepts' working from home edition. The volatility became very high when the CBOE Volatility Index increased by 60% from January 14th to January 26th. The S&P 500 started the week down by almost 3% on Monday and then climbed back with a 4% return before the end of the day for one of the most volatile trading days in a very long time. With growth-oriented stocks such as Netflix down almost 30% since the beginning of the year, some investors are looking for value-oriented companies with strong fundamentals that will perform well in a rising rate environment. Many investors believe that the value style of investment management tends to perform relatively better when interest rates are increasing. Investors who use the value style of investment management hope that the stock price will rise as more people come to appreciate the true value of the company's fundamental business.

Today, let's take a look at a value-oriented strategy that focuses on companies with strong fundamentals.

As always, we are going to start by selecting our universe of stocks, which includes all 2,000 companies in our U.S. database. We've chosen to rank our stocks according to four key value metrics and one momentum metric.

The first value metric is the enterprise value to EBITDA. The enterprise value to EBITDA ratio is frequently used to determine the value of the business if it is to be acquired. The next three factors are sector-specific because it can be more meaningful to use comparable ratios between similar companies. The industry-relative price to cash flow is fairly straightforward, and it's an indication of how much you are willing to pay for the operating cash flow of the business. The next factor is the industry-relative price to earnings, which is an indication of how much you are willing to pay for the earnings of the business. Our last factor is the industry-relative price to sales ratio, which is an indication of how much you are willing to pay for the sales of the business. Our only momentum metric is the three-month earnings revision because we want to find companies that analysts have a positive outlook for.

Now that we have our stocks ranked from 1 to 2,000, 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 10th percentile of our list, and we are only going to buy stocks that have a return on equity above 10%. This is a very good financial performance metric that incorporates leverage, return on assets and profit margin. We also want to eliminate most small cap stocks. So, we've placed a limit of 1.6 billion on the market cap size. We want to make sure that analysts have a positive outlook for the company's earnings per share, so we've used the earnings revision metric that's based on the average analyst expectation over the past three months. We've also used the variability around five-year earnings per share to make sure that companies have consistently reported strong earnings per share. Our last financial metric is the Morningstar quantitative health score, which is a proprietary metric that makes it easier to determine whether a company is in good financial health by measuring the likelihood that they will fall into financial distress. Here, we want to eliminate companies that are ranked in the bottom third.

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 20th percentile of our list.

Now, let's take a look at performance. The benchmark that we used is the S&P 1500 Value Total Return Index, and we tested this strategy from January 2006 to December 2021. Over this time period, this strategy generated a very strong 13.5% return, which is 5.2% higher than the benchmark and only a 26% annualized turnover, making this a very good buy and hold strategy. When looking at the annualized returns, we can see that the strategy outperforms the index over every significant time period. However, it does so with slightly higher price risk as you can see by the standard deviation. Although it has had slightly higher price risk, it's also had higher risk-adjusted returns as you can see by the Sharpe Ratio. That being said, this strategy does have slightly higher market risk as you can see by beta.

When looking at the performance chart, we can see very good outperformance over time, and when looking at the up and downside capture ratios, we can see that this is not only a strategy that has performed well in up markets, but it's also protected the strategy very well in down markets. Overall, this strategy has a very strong market capture ratio, showing that it has performed well throughout different market cycles. This is a great strategy to consider if you are looking for value stocks that have good financial performance. It's important to note that this strategy generally has more volatility when looking at the price and market risk, but it also has better financial metrics such as the debt to equity and the cash flow to debt. 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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