What are we looking for?
A portfolio of Canadian stocks with a low one-year, three-year and five-year beta.
The screen
One concept that I regularly incorporate into my equity strategies is beta. Beta is a great way to reduce risk in volatile markets by limiting the amount of sensitivity a stock can have compared with a specified benchmark. Recall that a beta of less than one indicates a company has historically moved less than the benchmark, based on price data across a specified time period – in other words, a lower beta is preferred. For today’s article, all references to beta use the S&P/TSX Composite Total Return Index as the benchmark.
Today’s strategy looks for Canadian stocks with a low measure of beta across multiple time periods. The purpose of this strategy is to produce a portfolio that has lower volatility in down markets than the S&P/TSX.
This strategy ranks stocks based on one-year, three-year and five-year beta (three different factors, for all of which lower values are preferred). Stocks that qualify must have:
- Five-year beta less than one (to reduce market sensitivity);
- Historical earnings variability in the lowest two-thirds of peers (measures the volatility of a company’s reported earnings per share; today this translates to a value 16.8 per cent or lower);
- Market capitalization in the top two-thirds of peers (today this translates to a market cap greater than $157.6-million).
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 120 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 October, 1990, to May, 2020. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their five-year beta rose to 1.2 or higher or if their earnings variability rose into the highest third of peers. 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 13.2 per cent while the S&P/TSX advanced 8.2 per cent on the same basis.
The downside deviation for the strategy was 6.7 per cent, compared with 9.9 per cent for the S&P/TSX Total Return Index. (Downside deviation measures the variability of negative returns; a company with more volatile negative returns would have a higher downside deviation, which indicates a greater risk.) It is also worthwhile to note that during periods the market declined (defined as quarters the index experienced negative returns), the strategy outperformed 76 per cent of the time.
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 shown here.
Emily Halverson-Duncan, CFA, is a director, CPMS sales at Morningstar Research Inc.
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Emily Halverson-Duncan, CFA