Quant Concepts: Financially Fit Companies

This strategy from Phil Dabo finds financially healthy companies using a predicitve model related to default risks.

Phil Dabo 6 May, 2022 | 4:58AM
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Phil Dabo: Welcome to Quant Concepts working from home edition. We've experienced a lot of volatility in financial markets over the past four months, and the United States just reported the first negative quarter of real GDP growth since the beginning of the pandemic. Times like this make it even more important to invest in companies that are financially healthy. Because it can protect us from having solvency and liquidity issues. We want to make sure that we're investing in companies with good balance sheets, as the Bank of Canada starts increasing interest rates even faster in an attempt to prevent runaway inflation. Today let's take a look at a strategy that focuses on companies that are financially healthy.

As always, we're going to start by selecting our universe of stocks, which includes all 700 companies in our Canadian database, we're going to rank those stocks from 1 to 700 according to four key factors. The first factor is our Morningstar quantitative financial health score. This is a proprietary variable that measures the probability that a firm will fall into financial distress. It uses a predictive model designed to anticipate when a company may default on its financial obligations. The next factor is our reinvestment rate. Because we would like to find companies that are growing organically by reinvesting in their business. We also want to find companies with a strong return on equity, which is a good measure of a business's financial performance. Our last factor is the 180 day standard deviation to reduce the amount of price risk in the portfolio.

Now that we have our stocks ranked, we're going to go through our screening process starting with our buy rules. We're only going to buy stocks that are ranked in the top 10th percentile of our list. We're only going to invest in companies that have a quantitative health score that ranks in the top third of our list. And this is going to eliminate companies that are not as healthy as others. We also want companies that rank in the top third of our list based on the reinvestment rate. And we want a return on equity of at least 10% which typically shows that the company is growing and has good financial performance. We're going to reduce downside risk by incorporating the 180 day standard deviation. And then we're going to include a few momentum factors, I use the price change to 12-month high because companies typically trading around the 12-month high have tended to continue performing well. And then I also incorporated the 50, the 200, and the 80 day moving averages.

Now let's take a look at our sell rules which are very simple. We're going to sell stocks if they fall out of the top 50th percentile of our list. And we're also going to sell stocks if their financial health deteriorates and falls to the bottom third of our list. Lastly, we're going to sell stocks if the 50 versus 200 day moving average goes above zero.

Now let's take a look at performance. The benchmark that we use is the S&P/TSX Total Return Index. And we tested the strategy from January 2006 to March 2022. Over this time period, the strategy generated a very strong 18.2% return which is 11.3% higher than the benchmark. But it also comes with a significantly higher annualized turnover of 118% which really comes from the momentum factors.

When looking at the annualized returns, we can see that the one year return is significantly worse than the benchmark, which is mainly because this strategy has not had exposure to energy stocks. And the energy sector has performed extremely well year-to-date. When looking at the longer term performance numbers, we can see that the strategy has outperformed the benchmark over every significant time period. And it's done that with slightly higher price risk as you can see by the standard deviation. You can also see that this strategy has generated significantly higher risk-adjusted returns as you can see by the Sharpe ratio, and it also comes with lower market risk as you can see by beta.

When looking at the performance chart you can see very good outperformance by the strategy over time. And when looking at the up and downside capture ratios, you can see that this strategy has done well in protecting on the downside while still participating in up markets. Overall, this strategy has performed well throughout different market environments. This is a great strategy to consider if you're looking for companies that are in a good financial position. On top of that strategy has had really good performance in relation to the S&P/TSX. You will also notice that the buy list has a good amount of diversification, with companies ranging in size from micro caps to large caps, with yields that range from zero to 5%. You can find the buy list along with a 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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