Quantitative concepts: success of small and mid caps
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Phil Dabo: Welcome to the work-from-home edition of Quant Concepts. Small-cap stocks have done quite well recently, with the S&P Small-Cap Total Return Index yielding 13% last year and 14% year-to-date, which is better than the S & P / TSX Total Return Index as a whole. While small-cap stocks can be too volatile for some investors and lack cash for others, they can offer significant diversification benefits to your portfolio.
Today let’s take a look at a very interesting strategy that combines two models with a focus on small and mid cap stocks which can generate less volatility.
The first model we have will use the 700 stocks in our Canadian database, and then we will rank those stocks based on the normal growth rate of five-year earnings per share, five-year average return on equity, rate of return. five years. annual standard deviation of the price, the five-year deviation around earnings per share, and finally beta.
Now let’s see the rules for purchasing our first model. We will buy stocks that are in the top 25th percentile on our list, and we will only buy stocks with a free float greater than $ 70 million but less than $ 1 billion. The five-year earnings per share spread should be in the top third of our list. We also want positive values for the average ROE over the past five years, trailing ROE, normal five-year earnings per share growth rate, quarterly earnings dynamics, three-month price change, and growth. adjusted book value.
Now let’s take a look at the sales rules for our first model. We are going to sell stocks that fall out of the top 35th percentile on our list. We will also sell stocks if they have a negative value for the five-year average ROE, the final ROE, and the normal growth rate of five-year earnings per share. We will also sell stocks if their quarterly earnings dynamics fall below -5%.
Now that we have our buy and sell rules to identify more stable small cap companies, we’ll combine them with our buy and sell rules and identify value driven small and mid cap stocks. To identify value-driven small and mid-cap stocks, we’re going to rank our stocks from 1 to 700 based on trailing earnings price, trailing cash flow price, beta, and cash flow dynamics. quarterly free cash flow.
Now let’s see the rules for purchasing our second model. We will only buy stocks that are in the top 10th percentile of our list, and the stocks must have a beta of less than 2, a market cap of less than $ 12 billion, relative debt to equity of the industry at the top. two-thirds of our list, a return on equity in the top third of our list, and a price change to the 12-month high in the top third of our list, because companies that are trading near their highest of 12 months performed well.
Now let’s take a look at the sales rules for our second model. We will only sell stocks that are not in the top 20th percentile on our list.
Now that we give each of the two models a 50% weight, let’s take a look at the performance. The benchmark we used is the S & P / TSX SmallCap Total Return Index, and we tested this strategy from January 2004 to April 2021. During this period, this strategy produced a very good return. 20.4%, ie 16.2% more than the index with an annualized turnover of only 48%. We can see that this is a strategy that has outperformed the benchmark over every significant period of time, and that with much less price risk, as you can see by the standard deviation. This contributes very well to higher risk-adjusted returns, as you can see by the Sharpe ratio, and you can also see that this is a strategy that generated very good alpha with less risk of market, as you can see in beta.
Looking at this chart, you can see very good performance over time, especially over the past year. And looking at the upside and the downside catch, you can see that this is a strategy that has worked well over different market cycles, which contributes very well to an overall market capture ratio. This is a great strategy to consider if you are interested in small and mid cap stocks that can add alpha to your portfolio. Over the past 15 years, this strategy has produced only negative returns for the calendar year in 2018 and 2008. In addition to very strong historical performance, some of the stocks on the buy list may offer exposure to lesser-known stocks that can add diversification. your wallet. You can find the shopping list with the transcript of this video.
From Morningstar, I’m Phil Dabo.