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Brandon Strong: Welcome to Quant Concepts. As inflation remains a prevalent issue in today's world, it might be time to aim for the middle. Russ Koesterich, BlackRock Portfolio Manager, said it best. With headlines focused on inflation and the Federal Reserve, rotations between growth and value stocks have become increasingly violent. Near term, this is likely to continue. While skilled market timers may try to get ahead of these moves, a different strategy is to embrace the middle – growth at a reasonable price.
While GARP tends to outperform in most regimens, the exception has historically been where we are today – high and accelerating inflation. That said, both growth and inflation are likely to moderate towards mid-year for a variety of reasons, including a substantial reduction in fiscal stimulus, along with an eventual easing of supply chain-related issues as the current Omicron wave passes and existing untapped labour pools can help fill a record number of job openings. While near-term conditions still support value, rather than trying to pivot every three months, the middle may be a more sensible place to be, at least for the longer term.
With that said, let's work through a strategy with a good blend of value and growth characteristics. Today, let's take a look at a strategy with a focus on growth at a reasonable price. Let's start by ranking our universe of around 2,000 stocks. In the ranking step, we are going to look at nine different factors, some that are more unique than others, as you can see here.
The first factor is a quantitative economic moat, a proprietary factor intended to describe the strength of a firm's competitive position. The rating is expressed as wide with a value of 5, narrow with a value of 3 and no moat with a value of 0. The next factor we have is proprietary to Morningstar as we saw before. We call this factor the quantitative financial health rating. This calculates the likelihood that a company will face financial problems in the near future. The calculation uses a predictive model designed to anticipate when a company may default on its financial obligations. The financial health score is expressed as weak with a value of 1, moderate with a value of 2, or strong with a value of 3.
The next few factors are a lot more common in GARP strategies. We have trailing reinvestment rate, a measure of trailing EPS, less trailing dividends per share as a percentage of a company's adjusted book value per share. Price to forward earnings on current year median EPS, which is the ratio of a company's latest price to its forward-looking earnings per share. We have five-year normalized earnings growth, which measures the annual compound growth of earnings per share over the last five years. And specifically based on next quarter, we have quarterly earnings momentum which measures the estimated rate of change of quarterly operating earnings per share using earnings from next quarter. We have our three and nine-month price change as you could see. And lastly, we have three-month estimate revision, which measures the percentage change over the past three months in the current fiscal year median earning estimate. This is not part of the typical GARP strategy. However, we want companies that have positive sentiment from analysts on the street.
Now, let's run through the screening process. As you can see here, we are only going to select stocks that rank in the top fifth percentile of our list as we want the upper echelon of GARP (based) stocks. We are going to exclude companies with a narrow or no moat competitive landscape and screen out companies if their health score is subpar. We added a few screens on price change as this will help round out the strategy. And lastly, we added a small screen on market cap purely for liquidity reasons.
Next, let's take a look at our sell rules. We are going to sell stocks that fall out of the top 25th percentile of our list. Taking a look down here, we indicate this with a screen of 2. However, if a company begins to tumble into financial distress, we will screen it out of the model. We included two additional screens on price change as you can see. The markets have been somewhat irrational. So, it's best to protect ourselves from the downside of the underlying stock's price movement.
Now, let's take a look at our back test page. In our back test, we've started the period from April 2004, and we've run it until February 2022. Over that time period, we've seen notable outperformance in every timeframe except the one near number as you can see here. This makes a lot of sense, as momentum investors were rewarded the most during the COVID years, and value tends to underperform significantly.
Taking a look at this strategy's downside deviation, which is here, you can see that the percentages are very similar if not even down the board. Our strategy tends to hold up during market downturns which is nice to see as we are bracing for higher inflation and a possible economic recession. Furthermore, we can see that this strategy has lower or equal beta over every time period. This indicates that we have less market risk, which is ideal for the current climate. And lastly, we can see significant alpha generated from the strategy.
I also like to take a look at the market capture ratios. We can see that this strategy has a notable downside capture ratio, which indicates that the strategy holds up, again during market downturns. As mentioned before, we've seen significant outperformance since '04, but most importantly, the strategy holds up in the long run. During times of economic distress, as we saw with the market crash of '08, the strategy still managed to outperform the respective benchmark. Again, if you are looking for a strategy that identifies companies with growth at a reasonable price, please make sure to check out the buy list accompanying the transcript of this video.
From Morningstar, I'm Brandon Strong.
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