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Quant Concepts: Low Risk, High Growth Stocks

Phil Dabo's strategy reduces market risk but also has higher reinvestment rates to capture stocks that are growing organically by investing in profitable growth opportunities.

Phil Dabo 12 August, 2022 | 1:42AM
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Phil Dabo: Welcome to Quant Concepts working from home edition. There has been so much volatility in financial markets this year with interest rates going up along with inflation and global economic growth slowing down significantly. A lot of investors that are interested in growth-oriented stocks may also want to reduce the amount of volatility in their portfolios. Beta is a frequently used statistic for measuring how much market risk is in a portfolio. It can also be used as a measure for the amount of volatility that a stock has compared to the financial market as a whole.

Today, we are going to take a look at a strategy that reduces market risk but also has higher reinvestment rates to capture stocks that are growing organically by investing in profitable growth opportunities.

Now, let's take a look at our strategy. We are going to start by selecting our universe of stocks, which includes all 700 companies in our Canadian database. Next, we are going to rank those stocks from 1 to 700 according to four key factors.

The first factor is beta to reduce the amount of market risk in the portfolio. The next factor is the quarterly earnings momentum, because we want companies that are growing their bottom line. We also use the reinvestment rate to capture companies that are taking those earnings to reinvest in profitable growth opportunities. Lastly, I used the price change to 12-month high, because we found that companies trading close to their previous 12-month high tend to continue performing well.

Now, let's go through the screening process by starting with our buy rules. We are only going to buy stocks that are ranked in the top 25th percentile of our list, and if the annual earnings momentum is greater than 0. We are only going to buy stocks that have a beta of less than 1, which is equal to market risk, and we are going to reduce price risk by using the 180-day standard deviation and excluding the bottom two-thirds of stocks that have the most volatile stock price. We are going to reduce the amount of exposure to smaller companies by placing a market cap limit of $1 billion. We also don't want companies with excessive amounts of debt. So, I have eliminated stocks that have the highest debt to equity ratios. Lastly, I placed a limit on the price change to 12-month high so that we are only buying stocks that are ranked in the top two-thirds.

Now, let's take a look at our sell rules, which are very simple. We are going to sell stocks if they deteriorate and drop out of the top 60th percentile of our list and if their annual earnings momentum drops below 0. We are also going to sell stocks if their debt to equity ratio becomes too large and becomes greater than 90% of the other stocks on our list.

Now, let's take a look at performance. The benchmark that I used is the S&P/TSX Total Return Index, and we tested this strategy from January 2006 to June of 2022. Over this time period, this strategy generated a very strong 12.1% return, which is 6.2% higher than the benchmark with only a 34% annualized turnover, showing that this is a very good buy and hold strategy. When looking at the annualized returns, we can see very strong performance compared to the benchmark over every significant time period. And it's no surprise that this strategy generated lower price risk as you can see by the standard deviation. This has also contributed to superior risk-adjusted returns as you can see by the Sharpe Ratio. And also, no surprise that this strategy has lower market risk as you can see by beta.

When looking at this performance chart, you can see very strong performance over time. And when looking at the up and downside capture ratios, you can see that this strategy met our objective of protecting the portfolio during down markets, and it's also contributed nicely during up markets, showing that this is a strategy that has performed well throughout different market cycles. This is a great strategy to consider if you are looking for Canadian companies that are generating earnings momentum and have less volatility than the overall market. You can find the buy list along with the transcript of this video.

From Morningstar, I'm Phil Dabo.

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Phil Dabo  Phil Dabo is Director, CPMS Sales

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