Quant Concepts: Diversify by Going Domestic

By including small American companies that benefit from domestic economic growth, Phil found a strategy that's outperformed in times of broad market uncertainty.

Phil Dabo 8 April, 2022 | 4:28AM
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Phil Dabo: Welcome to Quant Concepts. There's a lot of uncertainty surrounding the economy right now with a lot of analysts concerned that there might be a recession coming around the corner. The main concerns are that interest rates are rising, inflation remains stubbornly high, and there's no shortage of geopolitical risks. There are also a lot of positive takeaways from the economy right now, such as strong economic growth, strong corporate fundamentals and very low unemployment. All this being said, it's even more important to diversify your portfolio when uncertainty is at an all-time high.

Today, let's take a look at a strategy that focuses on small American companies that can diversify your portfolio.

As always, let's start by selecting our universe of stocks, which includes all of the small American companies in our database with a market cap of less than $2 billion. Next, we are going to rank our stocks according to five key factors.

The first factor is the price to trailing sales to find companies that are trading at a discount. Next, we are going to take a look at trailing return on equity, which is a good financial performance metric that takes into consideration the leverage, profitability and return on assets of the company. The next three metrics have to do with earnings per share. We want to find companies that are expected to grow their earnings per share next quarter, where analysts have a positive outlook in terms of earnings per share and where the company is able to beat those expectations on a quarterly basis.

Now that we have our stocks ranked, we are going to go through the screening process, starting with the buy rules. We are only going to buy stocks that are ranked in the top 30th percentile of our list, and we are only going to buy stocks with a return on equity above 20%. Stocks need to be ranked in the top third based on the three-month estimate revision and based on the price change to 12-month high. This is a very good momentum metric with downside protection because what we've found is that stocks trading close to their previous 12-month high have tended to continue performing well. Our last buy rule is the market price versus its 80-day moving average. We want to prevent companies from experiencing the maximum drawdown within the market. So, we've placed a buy rule of negative 5%.

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 50th percentile of our list and if the stocks fall to the bottom third based on the three-month estimate revision. Our last sell rule is very important. It's a market price versus its 80-day moving average, and the model is going to move into cash if the number becomes worse than negative 5%. This is to avoid maximum drawdowns within the market.

Now, let's take a look at performance. The benchmark that we used is the S&P 500 Total Return Index, and we tested the strategy from January 2006 to February 2022. Over this time period, the strategy generated a very strong 23.9% return, which is 13.7% higher than the benchmark and an annualized turnover of 167%, which is quite high. We can see by looking at the annualized returns that this strategy outperformed the benchmark over every significant time period. However, it's done so with significantly higher price risk as you can see by the standard deviation. Although the standard deviation was significantly higher, the strategy still generated significantly higher risk-adjusted returns as you can see by the Sharpe Ratio. It's also important to note that the strategy generated very strong alpha with slightly lower beta.

When looking at this chart, we can see very good outperformance over time, and when looking at the up and downside capture ratios, we can see that this strategy has performed well throughout different market environments. This is a great strategy to consider if you're looking to add some diversification to your portfolio with small American companies. Although there may be some liquidity risks, these companies have generally had really good performance over the past 12 months. They are also really well-positioned to take advantage of domestic economic growth because they don't have a lot of multinational operations and there's likely to have really good economic growth in the U.S. throughout the year. 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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