Quantitative Concepts: Deep Value for Corrections


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Brandon Strong: Welcome to Quant Concepts. As the month of February draws to a close. It’s important to think about some of the top stocks in the market this month. Investors face two potential problems, rising tensions between Russia and Ukraine and rising bond yields. Speaking from an investor’s perspective, one concern about the war is that Russia, one of the world’s largest oil producers, would see its supply cut off, most likely by sanctions. This would cause oil prices to spike, hurting consumers who are already struggling with the current level of inflation. Other yields of concern could rise further from here, as the yield on 10-year Treasury bonds is still lower than the longer-term expected annual inflation rate.

The two events in tandem contributed to the market’s slide last week, with the S&P and Nasdaq falling more than 2% and the Dow Jones having its worst day of the year. Some are preparing for a correction, and we believe we have a strategy suited to the most conservative investor. Today, let’s look at a strategy that identifies companies with deep value characteristics. Let’s start by ranking our universe of about 715 stocks. In the ranking step, we’re going to look at five main factors which you can see here.

The first factor is the book price, which is the ratio of a company’s last trading price to the per share value of its common stock. It is one of the most commonly used measures of a company’s value and is useful when applied to capital-intensive businesses such as energy. And as we know, energy is currently a hot sector to watch. The next three factors we can address at once. The first factor is price to cash flow, which is the ratio of a company’s price to its last four quarters of operating cash flow. Second, we have the forward price/earnings ratio, which is the ratio of a company’s last price to its forward earnings per share. And the third factor price to ending sales, which is the ratio of a company’s last price to its ending sales.

We want to cover all three data points because the effectiveness of each factor depends on the company in question. So, for example, the price to cash flow ratio is a more effective metric when used for companies with large non-cash expenses such as depreciation. And the last factor is the revisions estimate from 90 days, which is the estimated revision of the current year’s median EPS from 90 days ago. By including this factor, we hope to select companies that have positive sentiment from analysts on the street.

Now let’s review the selection process. Here, as you can see, we’re only going to select stocks that rank in the top 20th percentile of our list. This threshold will give us a good number of eligible stocks to choose from so that we can be fully invested in the strategy. The first screen we used is simple. But we want to exclude companies that do not have sufficient volume. Here we cap the volume at a C+. Next, we placed a screen on the financial health score factor. Again, this factor is useful in estimating a company’s distance from default. We want to use this as an extra layer of security since we don’t control our earnings, sales, and cash flow factors discussed earlier. And finally, we have some additional small screens. This one in particular is used to screen companies under bankruptcy protection.

Next, let’s look at our sales rules. So we keep things very simple here. Since we are not buying on our value factors, we will not be placing screens on them either. And we just want to have a few moving parts here. Our sell threshold would therefore be below the 45th percentile. And we put a screen on the quantitative financial health score of a D- of 0.41. And just as we saw on the buyer side, we’re also going to include smaller screens here. For example, bankruptcy protection.

Now let’s take a look at our backtest page. Here we use the MSCI Value Index as a benchmark as we believe it is more comparable to our strategy. We started the period from May 2001 to January 2022. During this period, we saw a notable outperformance with a return of 13%, 4.3% more than the benchmark. Additionally, our strategy has 35% annualized revenue. This is a good indication that this is a solid buy and hold strategy. Looking at the percentage return over the different time periods, which is here, we can see that there have been consistent returns since the start of the strategy, the only time period that underperformed was last year as this has been something of an anomaly in the market. The strategy has a lower or equal beta on each period. We can also see significant alpha generated by the strategy.

In terms of risk characteristics, we tend to have a higher standard deviation than our benchmark, but we reap the extra reward for the extra risk. As mentioned earlier, we have seen outperformance since 2001. But more importantly, over the past 20 years, we have seen steady and consistent performance. Also, I like to take a look at the market capture ratios, we can see that this strategy has a noticeable upside capture ratio, and overall it tends to beat the index of overall reference. Again, if you’re looking for a strategy that identifies companies with deep value traits, be sure to check out the shopping list accompanying the transcript of this video.

From Morningstar, I’m Brandon Strong.

Find the shopping list here.

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