Quantitative concepts: value and income in times of volatility

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Brandon Strong: Welcome to Quant Concepts. Over the past few weeks, the market outlook has remained quite bleak. What little optimism remains is the result of rebounds in both the energy and financial sectors. While these sectors have performed well, it’s important to keep in mind that some of the largest stocks on the S&P and TSX have kept the indices relatively stable in terms of overall performance. The markets appear to be better than they really are, and the broader market as a whole is experiencing turbulence following the rising rates and uncertainty of the Omicron Variant. To stay proactive rather than reactive, we believe it is best to move from a more aggressive strategy to one that is more conservative in nature. In doing so, we aim to reward investors in the form of consistent and regular dividends until confidence is restored in the market.

Today, let’s look at a strategy that identifies companies with low risk, high value and consistent returns.

Let’s start by ranking our universe of about 715 stocks. In the ranking step, we’ll look at four main factors, which you can see here. The first factor is expected dividend growth, which is the ratio of a company’s expected annual dividend to its actual dividend paid over the past four quarters. It is a common measure of risk used by a company and can be used to assess whether the company is increasing its dividend from the previous year. The next factor is the expected payout, which is the dollar amount of estimated dividends to be paid over the next 12 months, expressed as a percentage of estimated EPS to be earned in the current fiscal year. This ratio is important to see how much profit a company is expected to pay out in the form of dividends. If the payment is too high, the company will not be able to maintain the dividend.

The next factor is the Quantitative Financial Health Score, which ranks companies based on their likelihood of falling into financial difficulty. Using two main indicators of leverage, the ratio of enterprise value to market value and stock volatility relative to the rest of the universe, he estimates a company’s distance to default. And finally, the expected dividend yield, which is the estimated annual dividend yield, is expressed as a percentage of the stock’s last market price. We only want actions that generate income.

Now let’s review the selection process. As you can see here, we will only select stocks that rank in the top 10th percentile of our list, maintaining very strict buy discipline. We will exclude companies that have not increased their dividend every year for the past three years. The expected dividend must be at least above C+ and the yield above 0.5%. Our quantitative financial health score must be above 0.7 because we want companies with very strong balance sheets. We have included a screen on estimate revisions so that we can select stocks with a relatively positive outlook in terms of analysts’ expectations. And finally, we put the screen on market capitalization, as larger companies tend to be more established and hold their own during times of uncertainty.

Next, let’s look at our sales rules. In this case, we’ve kept things very simple with just a few selling rules. We’ll exclude stocks that are in the lower 50th percentile from our list, and we’ll eliminate stocks with negative valuation revisions below a D-. We would also like a quantitative financial health score below 0.35, because we want to reiterate that we want companies with strong balance sheets and exclude others.

Now let’s take a look at our backtest page. In our backtest, we started the period from January 2007 to December 2021. Over this period, we saw a very good outperformance with 10.7%, which is 4% more than the benchmark index. And with only 31% annualized turnover, this strategy can be considered a solid buy and hold type strategy. Looking at the standard deviation, which is here, we can see that there have been standard deviations of lower returns over the majority of time periods. This contributes to better risk-adjusted returns, as measured by the Sharpe ratio, and we could also see that it outperformed the benchmark over the long term, even though it missed the target on shorter periods. We can see that this strategy has a lower beta on each time frame, which means we are less risky than the market. We can also see significant alpha generated by the strategy. As mentioned earlier, we’ve seen outperformance since 2007, but more importantly, over the past 10 years, we’ve seen steady and consistent returns.

If you’re looking for a strategy that identifies low-risk, high-value, consistent revenue businesses, be sure to check out the shopping list accompanying the transcript of this video.

From Morningstar, I’m Brandon Strong.

Find the shopping list here.

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