What are we looking for?
Momentum-driven stocks that also mitigate risk.
The screen
In a previous Number Cruncher, I used Morningstar CPMS to create a momentum strategy that protects on the downside. Today, I repeat this exercise for the U.S. market.
As many investors know, while momentum strategies can offer attractive returns, they also tend to come with a lot of risk and frequent trading. The theory I'm testing is when we combine a typical momentum strategy with a couple of risk-mitigating factors, to see if we can generate attractive returns while keeping volatility and trading at a minimum.
This strategy ranks stocks using the following factors:
- Quarterly earnings momentum (measured as the growth in the most recent trailing four quarters earnings relative to the trailing four quarters earnings lagged by one month);
- Five-year normalized sales growth (a profitability metric);
- Trailing return on equity (ROE) relative to the industry median (high value is best);
- Quarterly earnings surprise (a proprietary measure of the difference between actual and expected quarterly earnings).
In order to qualify, stocks must have positive values for all four of the ranking criteria listed above. Stocks must also have a month-to-date price change greater than 0. Five-year sales growth is required to be in the top third of peers. Lastly, five-year beta (which measures a company's sensitivity relative to changes in the benchmark – here we use the S&P 500) must be less than 1.10 and five-year EPS (earnings per share) variability (which measures the volatility of a company's earnings per share across the past five years) must be lower than at least 50 per cent of peers.
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to back test this strategy from December, 1993, to September, 2017. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their rank fell below the top 40 per cent of the universe or if the company's month-to-date price dropped more than 15 per cent. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio.
Over this period, the strategy produced an annualized total return of 16.4 per cent while the S&P 500 Total Return Index returned 9.5 per cent across the same period. Downside deviation (measured as the variability of negative returns) was 9.0 per cent compared to the S&P 500 Total Return Index which had a downside deviation of 9.7 per cent. The top 15 stocks that qualify for purchase into the strategy today are listed in the accompanying table.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Emily Halverson-Duncan is an account manager for CPMS at Morningstar Research Inc.