Quant Concepts: Momentum Betting Against Volatility

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Joshua Farruggio: Welcome to Quant Concepts. It’s been a volatile start to the year, with investors battling high oil prices, global supply chain disruptions, Russia’s war in Ukraine and rising rates to fight inflation. While this environment screams risk aversion, it’s the perfect recipe for momentum-driven investors looking to capitalize on market ups and downs. This may not be a viable strategy for everyone; however, if coupled with risk factors, more investors may be open to this approach as it provides additional security.

Today, we’ll take a look at the Canadian market and focus on stocks that exhibit strong price, earnings and cash flow dynamics combined with risk factors.

Let’s start by selecting our stock universe which includes the 700 companies in our Canadian database. Next, we’ll rank our stocks from 1 to 700 using a few key factors. The first factor is our quarterly earnings momentum. This is the rate of change in quarterly operating profit. The second factor is our quarterly cash flow dynamics, looking at the rate of change in quarterly operating cash flow. The third and fourth factors will focus on the dynamics of price change over the past three and six months.

After that, we’ll look at three risk factors, weighted around 8% each, the first being earnings variability, which represents the volatility of a company’s reported earnings. We will also look at the annualized standard deviation of daily total returns for the past three years. And finally, we’ll look at our cash flow to debt ratio.

Now, let’s apply our purchasing rules. We will buy stocks ranked in the upper 30th percentile of our list. We look for companies with quarterly cash flow momentum above 1.5%. To measure earnings variability, we will place a median score to select stocks that show less variation from quarter to quarter. We will also do the same for a stock’s price movement over the past three years. Additionally, we will screen companies that have the ability to service their debts, placing a letter of B+, or in this case, a cash flow to debt ratio of 0.72. Finally, to ensure good liquidity in the model, we will apply a median score for the average monthly traded value of a stock.

Now let’s take a look at our selling rules. We will screen stocks if they deteriorate and fall from the upper 45th percentile. If a company’s cash flow to debt ratio falls below the bottom third of the universe, we will sell. And finally, we will sell if a company is not generating enough cash flow quarter over quarter, in this case below minus 3.89%.

Let’s take a look at the performance. The benchmark we used is the S&P/TSX Compound Total Return. And we tested this strategy from December 2006 to May 2022. Over this period, the strategy generated an annualized return of 12.1%, almost 6% higher than the benchmark index and an annualized turnover of 79 %, which is acceptable for a momentum model. This strategy has significantly outperformed each annualized period of our backtest. As most momentum patterns produce, the strategy has higher price risk, but a 0.5% lower downside spread than the benchmark. We also see risk-adjusted returns that double the amount of the TSX and lower market risk with a beta of 0.8.

Let’s take a look at the green and blue charts below. We beat the benchmark by 61% in bull markets and 70% in bear markets, demonstrating our ability to capitalize in all environments. This is a great strategy to consider if you are a momentum-oriented investor looking to mitigate risk. The companies are showing strong price and earnings momentum while proving sustainable cash flow and good risk indicators. Over the past 3.5 years, the model has produced a cumulative return of 86%, beating the market by 34%. You can find the shopping list with the transcript of this video.

From Morningstar, I’m Josh Farruggio.

Find the shopping list here.

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