Building a profitable and stable portfolio

Investors often fixate on the latest news and hot stocks popping up in investing media. They demand to know which stocks or sectors should they should invest in next. When they do get an answer, they are often steered towards to stocks or sectors that have been trending recently, but often these only perform for the short term.

While short term momentum has shown some success indicating future performance, momentum style investing can be extremely volatile and exhibits high turnover. In simple terms: it’s not suitable for everyone. For investors particularly concerned with volatility and turnover, chasing what is “hot” is probably an inappropriate investment philosophy. Instead, focusing on more stable while profitable stocks is likely a more suitable choice.

Here is one equity strategy with lower volatility while producing high profits.

The criteria

Using Morningstar CPMS, which comprises of about 98% of the investible market cap of stocks in Canada, I screened for equities with the following characteristics:

• Low standard deviation of the stock’s return for the last 90 days
• Low standard deviation of stock’s return for the last year
• High return on equity
• Market cap of at least $500 million

The results

I used Morningstar CPMS* to back-test the strategy from December 1999, to May 2017. During this process, a maximum of 20 stocks were purchased and equally weighted with a maximum of five stocks a sector to provide a degree of diversification. Quarterly, the portfolio would be reselected based on the strategy’s criteria. Over this period, the strategy produced an annualized total return of 13.7% while the S&P/TSX composite total return index advanced 6.1%.

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Downside deviation (a measure for volatility of negative returns) for the strategy was 5.3% vs. 9.9% for the S&P/TSX Composite. The lower the downside deviation indicates a lower history of “bad” volatility. Turnover was 126%, which means you would make 6 to 7 trades per quarter on this strategy. You can find a list of the 19 stocks that are currently in this strategy below.

A Word of Warning

The results of this strategy are impressive, but I should remind you that they are based on a back-test, which comes with its own assumptions. For example, this test assumed trading with closing day prices and only at the last business day of each quarter. In reality, you would likely trade at a different price and may transact at more frequent intervals. Also, this strategy uses only quantitative data based on the factors above. I recommend that you should also regularly pay attention to news on stocks that you own and ensure that conditions of those companies are worthy for investment based on your own research.

As always, past performance (back-tested or real life) may not be indicative of future results. Nevertheless, I believe this type of strategy and the current list of stocks are a worthwhile consideration if you are looking for a portfolio of profitable stocks with a history of low volatility.

Profitable and stable

* Morningstar CPMS includes all stocks in the TSX Composite Index and the BMO Small Cap index. It also includes other stocks based on request with at least 3 analysts of coverage and 5 quarters of earnings. Currently the universe has 722 stocks in Canada.

Michael Pe, CFA is an Institutional Product Specialist at Morningstar Research Inc.

About Michael Pe, CFA

As a CFA charterholder with over a decade of experience in the financial industry, Michael writes about the real estate market, personal finance and investing.

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