Brandon Strong: Welcome to Quant Concepts. Many individuals know that interest rates have a big impact on their debt. When interest rates rise, the cost of borrowing goes up. Well, rates also affect the way we invest. During times of rising rates and economic distress, a subset of money managers will encourage their clients to adjust their portfolios by using tactical asset allocation, straying away from the IPS to capitalize on the current macroeconomic environment. And these investment managers may overweight their clients’ portfolios in certain sectors, such as consumer staples, utilities, and financials, anything that would be considered defensive.
However, nothing is black and white when it comes to selecting the right investments. There are countless factors to consider, each adding a layer of complexity to your next investment decision. But if an investor looks for companies with deep pockets, attractive valuations and reasonable debt levels, we can feel better with our decision knowing that these companies are strapped in for turbulence. With that said, let’s identify companies with sufficient cash flow, modest debt, and desirable value characteristics.
Let’s start by ranking our universe of around 700 stocks. In the ranking step, we are going to look at six different factors, which you can see here. The first factor is price to trailing earnings, which is the ratio of a company’s latest price to its trailing four quarters of operating earnings per share. It is a commonly used valuation measure of a firm and can be interpreted as the multiple investors are willing to pay for a firm’s reported operating earnings. Next, we have price to book value, which is the ratio of a company’s latest price to the per share value of its common share equity, a common yet effective tool for assessing value.
Next, yield on expected dividends, which is the estimated annual dividend rate expressed as a percentage of the latest market price of the stock. We have price change from three months ago to capture short-term price momentum. With a higher degree of importance, we included cash flow to long-term debt, which is the ratio of a company’s trailing four quarters of cash flow from operations to the latest quarterly long-term debt. And last but not least, we have net debt to EBITDA, which measures the amount of income generated and available to pay down debt before covering interest, taxes, depreciation and amortization expenses. We want companies that can service their debt with ease.
Now, let’s run through the screening process. We are going to select stocks that rank in the top 20th percentile of our list. The three-month price change needs to be above a C+, essentially in the top two-thirds of the universe based on quarterly price change. The average monthly value traded needs to be above a D+, as we need enough liquidity to get in and out of our positions. And to add a few quasi growth elements to our strategy, we set a threshold of a C+ on three-year normalized ROE growth and quarter-to-quarter cash flow momentum.
Next, let’s take a look at our sell rules. In this case, we have kept things very simple with only two sell rules. We are going to remove stocks that fall below the 45th percentile of our list, and we’ll screen out stocks that have a price change from three months ago less than a D-.
Now, let us take a look at our back test page. In our back test, we started the period from April 2012 and ran it until June 2022. Over that time, the strategy outperformed in each time period except the one-year number. Although performance took a hit around, we say, March 2022, the overall performance and the strategy’s composition are solid. Looking at the standard deviation, which is here, we can see that our standard deviation is much higher compared to the benchmark. We excluded screens on risk and liquidity factors such as EVR, market cap and beta, and this increased the overall risk of the portfolio, but some of that risk translated into excess return. The downside deviation is comparable to the benchmark, and the strategy is generating significant alpha over the long run.
Now, quickly looking at the market capture ratios below, with above 60% in up and down markets, I can say with some confidence that this strategy is well-rounded. If you are looking for a strategy with a focus on cash flow, low debt and value, please make sure to check out the buy list accompanying the transcript of this video.
Thank you all for watching. From Morningstar, I’m Brandon Strong.