Quant Concepts: Go for the Moats

Find out how Phil Dabo's strategy filters for companies with earnings momentum and enduring competitive advantage. 

Phil Dabo 22 April, 2022 | 4:28AM
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Phil Dabo: Welcome to Quant Concepts. The S&P 500 has had a very challenging start to the year with a negative return of almost 10%. To put this in perspective, the index has had double-digit returns for each of the last three calendar years. So, it might seem as though the market has lost a little bit of steam and momentum these days. At times like this, it's even more important to look for companies that have really strong business models and financial statements. Companies that have a really strong competitive advantage should be able to provide more consistent investment returns because they're able to produce goods and services more efficiently than competitors, which eventually leads to greater profit margins.

Today, let's take a look at a strategy that focuses on companies that have a sustainable competitive advantage.

As always, we are going to start by selecting our universe of stocks, which includes all 2,000 American companies in our database. Next, we are going to rank our stocks from 1 to 2,000 according to six key factors.

The first factor is the Morningstar Quantitative Economic Moat Score to make sure that we are selecting companies with a clearly defined sustainable competitive advantage. Our next three factors have to do with earnings per share. We want companies that have really good annual and quarterly earnings momentum and are expected to grow their earnings per share next quarter. It's important to also have really good momentum in price. That's why I've used a price relative to the 50-day moving average to find companies that have a price that's trending in a positive direction. Lastly, I used the reinvestment rate using earnings per share to find companies that are generating earnings and able to reinvest in their business for profitable growth opportunities.

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. We are only going to buy stocks with a Morningstar Economic Moat Score of 5, which means that the stock has a wide, sustainable competitive advantage. We are only going to buy stocks that are mainly large cap, each company has to be ranked in the top third based on the reinvestment rate and they have to have a return on equity above 20%. The return on equity is a very good financial performance metric that takes into consideration leverage, return on assets and profitability. We want companies that are expected to grow their earnings momentum next quarter. And we want to reduce the amount of earnings variability, and so, a company has to be ranked in the top third based on the five-year earnings per share variability. We've reduced the amount of price risk in this strategy by placing a buy rule of 30% on the 180-day standard deviation and a company also has to be ranked in the top third based on the Morningstar Quantitative Financial Health Score. This will make sure that the companies are less likely to fall into financial default.

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 20th percentile of our list. We are also going to sell stocks if their Economic Moat Score deteriorates and drops below 5. We are also going to sell stocks if their earnings variability increases and falls out of the top third of our list. The same holds for the Morningstar Financial Health Score as a company has to be ranked in the top third, otherwise it will be sold from the list. If a company has a price that becomes too volatile, it will also be sold from the list.

Now, let's take a look at performance. The benchmark that we used is the S&P 500 Total Return Index, and we tested this strategy from January 2006 to March 2022. Over this time period, this strategy generated a very strong 15.4% return, which is 5.1% higher than the benchmark and only a 43% annualized turnover. When looking at the annualized performance, you can see that this strategy has outperformed the benchmark over every significant time period, and it's done so with market-like price risk as you can see by the standard deviation. It's important to note that this strategy has still generated significantly higher risk-adjusted returns as you can see by the Sharpe Ratio, and it's also had slightly lower market risk as you can see by beta.

When looking at the performance chart, you can see very good outperformance over time. And it's also important to note that this strategy hasn't had a single negative calendar year over the past 10 years, and the only negative calendar year return that it had since 2006 was during the financial crisis of 2008, and the strategy still outperformed the benchmark by 2%. When looking at the market capture ratios, you can see that this strategy has performed well throughout different market cycles. It has outperformed during up markets and down markets showing that this strategy has performed well throughout different market cycles.

This is a great strategy to consider if you're looking for companies that have good earnings momentum and a sustainable competitive advantage that can protect companies' profitability. The buy list is made up of companies that are mainly larger and have proven to be leaders in their respective industries. 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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