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November can be a cold and gloomy month for many Canadians, but they can ward off its chill by adding a little Irish cheer to their hot chocolate as they watch the first snows roll in.

Mixing fine ingredients can also work wonders in the markets and many investors have enjoyed big returns by combining well-known investment factors.

Today, I’m going to add a low-volatility twist to the value-oriented Canadian Free Cash portfolio to test the combination.

In its regular form, the portfolio gained an average of 15.7 per cent annually over the 25 years to the end of September. In comparison, the S&P/TSX Composite Index climbed by an average of 7.9 per cent annually over the same period. (The returns herein are based on backtests using monthly data from Bloomberg that include dividend reinvestment but not fund fees, taxes, commissions or other trading costs.)

The Canadian Free Cash portfolio starts its search for bargains with the largest 300 common stocks on the Toronto Stock Exchange. It then selects the 10 stocks with the lowest enterprise-value to free-cash-flow ratios, buys an equal dollar amount of each one and rebalances monthly.

As a quick refresher, enterprise value (EV) is equal to a company’s market capitalization plus its net debt. Free cash flow (FCF) is the amount of money a company can distribute to its shareholders while maintaining its operations. In this case, it is approximated by subtracting capital expenditures from cash flow generated by operations.

The portfolio’s long-term results are pretty grand, but some of my recent work pointed to the dangers of holding highly volatile stocks in Canada. For instance, a portfolio composed of the 30 most volatile stocks (over the prior 260 days) from the largest 300 on the Toronto Stock Exchange lost 0.3 per cent over the 25 years to the end of 2023. Gulp!

The observation prompted my hypothesis that removing the most volatile stocks might improve the returns, or lower the downside risk, of the Canadian Free Cash portfolio.

I tested the idea by creating two variants of the original portfolio that exclude highly volatile stocks in slightly different ways. The first is an eight-stock variant that removes the two most volatile stocks (over the prior 260 days) from the regular portfolio.

The second, a 10-stock variant, is a little more complicated. It begins with the largest 300 stocks on the Toronto Stock Exchange, removes the 20 per cent of stocks with the highest volatilities over the prior 260 days and then selects the 10 stocks with the lowest EV/FCF ratios.

Both variants fared better than the original portfolio, which gained an average of 15.7 per cent annually over the 25 years to the end of September. The 10-stock variant climbed at a 15.9-per-cent annual rate over the period while the eight-stock variant enjoyed average annual gains of 18 per cent.

In more happy news, the returns of both variants were slightly less volatile than the original Canadian Free Cash portfolio over the 25-year period.

The improvements look grand at first glance, but it’s important to take them with a grain of salt because they might be the result of jiggling the portfolio and thereby overfitting past results. That is, the variants might not provide the same lift in the future as they did in the past.

I have high hopes the Canadian Free Cash portfolio will continue to generate strong long-term returns (with some potentially alarming dips along the way). But I’ll also be keeping an eye on its more volatile components to see how they progress.

You can find a list of the stocks in the Canadian Free Cash portfolio via this link, which also provides updates to many of the other portfolios I track for The Globe and Mail.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.

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