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Quant Concepts: Financially Healthy Companies

As the economy may be set to slow down and rate hikes are around the corner, consider this strategy that's ourperformed when times get tough.

Phil Dabo 2 September, 2022 | 4:38AM
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Phil Dabo: Welcome to Quant Concepts' Working from Home edition. It has become even more difficult to predict where the economy will be over the next year because you've gone through an extraordinary period of growth, and now the economy is set to slow down. Over the past 10 years, this would have been a scenario where the Bank of Canada will be preparing to decrease interest rates. However, they're going to do the opposite by significantly increasing interest rates due to high inflation.

Today, let's take a look at a strategy that focuses on companies that are financially healthy and can potentially provide some downside protection.

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 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 might default on its financial obligations. The next factor is our reinvestment rate, because we'd 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' financial performance. The last factor is the 180-day standard deviation to reduce the amount of price risk in the portfolio.

Now, let's take a look at 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 and if the Morningstar quantitative financial health score ranks in the top third of our list. This will eliminate companies that are not as healthy as others. We want companies that are ranked in the top third of our list based on the reinvestment rate, and we only want companies that have a return on equity above 10%, which typically shows that the company is growing and has good financial performance. To provide downside protection to our portfolio we want a 180-day standard deviation below 49, which is the average for our investable universe.

Lastly, the next three metrics have to do with price momentum. We use the price change to 12-month high, because we found that stocks that have traded close to their previous 12-month high have tended to perform well. We use the 50-day and the 200-day moving averages along with the price relative to the 80-day moving average for the market to find stocks that are trending in the right direction.

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 we are also going to sell stocks if their financial health deteriorates and falls to the bottom third of our list. We are going to sell stocks if their price momentum is trending in the wrong direction based on the 50 and the 200-day moving averages along with the stock price relative to the 80-day moving average for the index.

Now, let's take a look at performance. The benchmark that we used is the S&P/TSX Total Return Index, and we tested this strategy from January 2006 to July of 2022. Over this time period, this strategy has generated a very strong 16.3% return, which is 10.1% higher than the benchmark and only a 41% annualized turnover. We can see by looking at the annualized returns that this is a strategy that has outperformed the benchmark over every significant time period. However, it's done so with market-like price risk as you can see by the standard deviation. Nonetheless, this strategy has generated superior risk-adjusted returns, as you can see by the Sharpe Ratio, and it also has lower market risk as you can see by beta.

When looking at this price chart, you can see very good outperformance over time. And more importantly, when looking at the up and downside capture ratios, you can see that this is a strategy that has performed very well in down markets while still participating very nicely in up markets, which has contributed to a very strong overall market capture ratio, showing that this is a strategy that has performed well throughout different market cycles.

This is a great strategy to consider if you're looking for companies that are in a really good financial position. On top of providing really good downside protection, this strategy has outperformed the index nine times over the past 10 years, including each time that the index was negative. 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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