Quant Concepts: Deep Value for Corrections

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Brandon Strong: Welcome to Quant Concepts. As the month of February comes to an end. It's important to reflect on some of the major headlines in the market this month. Investors are facing two potential issues, growing tensions between Russia and Ukraine and rising bond yields. Speaking from the view of an investor, a concern about war is that Russia, one of the world's largest oil producers, would see its supply disrupted, most likely by sanctions. This would cause oil prices to spike hurting consumers who are already struggling with the current inflation level. The other concern yields could still move higher from here as the 10-year treasury yield is still below the expected annual inflation rate for the longer term.

The two events in tandem contributed to last week's market slide as the S&P and Nasdaq fell more than 2% and the Dow had the worst day of the year. Some are bracing for a correction, and we believe we have a strategy tailored for the more conservative investor. Today, let's take a look at a strategy that identifies companies with deep value characteristics. Let's start by ranking our universe of around 715 stocks. In the ranking step, we're going to look at five main factors which you can see here.

The first factor is price to book, which is the ratio of a company's latest price to the per share value of its common share equity. It is one of the most commonly used value measures of a firm and is useful when applied to capital-intensive businesses such as energy. And as we know, energy is currently a hot sector to follow. The next three factors we can address at once. The first factor is price to trailing cash flow, which is the ratio of a company's price to its trailing four quarters of cash flow from operations. Secondly, we have price to forward earnings, which is the ratio of a company's latest price to its forward-looking earnings per share. And the third-factor price to trailing sales, which is the ratio of a company's latest price to its trailing sales.

We want to cover all three data points as the effectiveness of each factor depends on the company in question. So for example, price to cash flow is a more effective measure when used for companies with large non-cash expenses such as depreciation. And the last factor is estimate revisions from 90 days, which is the estimated revision of current year median EPS from 90 days ago. By including this factor, we hope to pick up companies that have positive sentiment from the analysts on the street.

Now, let's run through the screening process. Here as you can see, we're only going to select stocks that rank in the top 20th percentile of our list. This threshold will give us a healthy number of qualifying stocks to pick from so we can be fully invested in the strategy. The first screen we used is straightforward. But we want to exclude companies that do not have sufficient volume. Here, we cap volume at a C+. Next, we placed a screen on the quant financial health score factor. Again, this factor is useful for estimating a company's distance to default. We want to use this as an extra layer of safety since we're not screening on our earnings, sales, and cash flow factors discussed earlier. And lastly, we have a few additional small screens. This one in particular is used to screen out companies under bankruptcy protection.

Next, let's take a look at our sell rules. So we're keeping things very simple here. Since we are not buying on our value factors, we won't place any screens on them as well. And we only want to have a few moving parts here. So our cut-off for our sell-side would be below the 45th percentile. And we placed a screen on quant financial health score of a D- of 0.41. And just like we saw on the buy side, we're going to include some smaller screens here as well. For example bankruptcy protection.

Now let's take a look at our backtest page. Here, we're using the MSCI Value Index as our benchmark as we feel it's more comparable to our strategy. We started the period from May 2001 until January 2022. Over that time period we've seen some notable outperformance with a return of 13% which is 4.3% higher than the benchmark. Moreover, our strategy has 35% annualized turnover. This is a good indication that this is a solid buy-and-hold strategy. Taking a look at the return percentage over the different time periods, which is here, we can see that there has been steady returns since the inception of the strategy, the only period that underperformed came in the last year as this has been somewhat of an anomaly in the market. The strategy has lower or equal beta over every period. We can also see significant alpha generated from the strategy.

In terms of our risk characteristics, we do tend to have higher standard deviation than our benchmark, but we are reaping the extra reward for the added risk. As mentioned before, we've seen outperformance since '01. But more importantly, over the past 20 years, we've seen a steady consistent return. Also, I like to take a look at the market capture ratios, we can see that this strategy has a notable upside capture ratio, and overall it tends to beat the benchmark in aggregate. Again, if you're looking for a strategy that identifies companies with deep value characteristics, please make sure to check out the buy list accompanying the transcript of this video.

From Morningstar, I'm Brandon Strong.

Find the buy list here.