What are we looking for?
Canadian momentum-driven stocks with low market sensitivity.
The screen
Traditional momentum strategies are often associated with extremes – extreme ups and downs, extreme trading and extreme volatility. Typically, the investors of these types of strategies have a higher risk tolerance and are comfortable being active with their investing. While the long-term returns can be quite attractive, the accompanying risk level may make these strategies perceived by the average investor as too much to handle.
Today, I’m showcasing a strategy that incorporates some key momentum factors while placing a cap on each stock’s market sensitivity in hopes of reducing volatility on the downside. The hope here is to create a model that benefits from the upside of a momentum strategy while still having strong downside protection. This strategy ranks stocks using the following factors:
- Quarterly earnings momentum (measures growth in the most recent four quarters of earnings relative to the same four quarters of earnings lagged by one month, higher values preferred);
- Trailing return on equity relative to the industry median (a profitability metric, higher values preferred);
- Quarterly earnings surprise (measures the difference between actual and expected quarterly earnings, higher values preferred);
- Five-year annualized cash flow growth (a profitability metric, higher values preferred).
In order to qualify, stocks must have a value greater than or equal to zero for the first three metrics listed above. Stocks must also have both their one-day price change and month-to-date price change with values greater than or equal to zero. Five-year annualized cash flow growth is required to be in the top third of peers, which today has a value of 5.4 per cent or higher. Lastly, five-year beta (a measure of a company’s sensitivity relative to changes in the benchmark – here we use the S&P/TSX Composite Index) must be less than 1.1. Recall that a beta of one indicates the same level of sensitivity as the market, so putting a cap of 1.1 ensures a company’s sensitivity is not substantially higher than that of the relevant benchmark.
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.
What we found
I used Morningstar CPMS to back-test this strategy from October, 2002, to November, 2020. During this process, a maximum of 15 stocks were purchased. Stocks were sold if the company’s one-day or 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 21.3 per cent, while the S&P/TSX Composite advanced 8.1 per cent on the same basis.
It’s also worth pointing out the strategy outperformed the S&P/TSX in 83 per cent of down markets (defined as quarters where the index posted negative returns). Stocks that qualify for purchase into the strategy today are listed in the accompanying table. Note also that only eight stocks met the criteria for inclusion.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Emily Halverson-Duncan, CFA, is a director, CPMS sales at Morningstar Research Inc.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.
Emily Halverson-Duncan, CFA