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By Morningstar Canada | 04-04-2019

Refine your stock strategy with sleeves

Learn how to target company characteristics with pinpoint accuracy through the use of quantitative sleeves with Emily Halverson-Duncan, Director of CPMS Sales

Emily Halverson-Duncan: Sleeves in investing refer to groups of securities that have similar characteristics. These characteristics can be high-level, for example, splitting securities based on where they are located or distinguishing between different asset classes such as fixed income and equity. They can also be used at a more granular level. For example, splitting your international stocks into sub-groups based on how they've been selected. Several weeks ago, I created a Canadian strategy which focused on the latter type of sleeve looking separately for income and momentum stocks and then combining them together in a single Canadian equity portfolio. Today, I'm going to repeat this exercise in the U.S. So, let's take a look at how those sleeves we’ll be constructing.

So, first off, our first sleeve is a dividend growth sleeve. So, what we're looking for are income-focused stocks, pretty low volatility and more large-cap type names. So, here we can see we are ranking stocks based on expected dividend yield, so what the company is expecting to pay out in dividends. Their 5-year beta, so that's a measure of how sensitive a stock is compared to the index which in this case is the S&P 500. 5-year dividend growth. So, again, we are looking for a longer-term growth metrics.

Some of the screens that we applied for this sleeve want a dividend yield to be greater than equal to 2%. So, anything less than 2%, we wouldn't be buying that stock. A three-month earnings per share estimate revision that's at least negative 5%. So, what that means is, across the last three months if your earnings per share declined 5% or higher, that would be okay. If it declined more than that, then we wouldn't purchase it. And then, on the sell-side, we would be selling if the dividend yield fell below 1%. So, if the yield is no longer attractive. So, that's our first sleeve.

Our second sleeve is a momentum sleeve. For the momentum sleeve, we are looking at stocks that will be a little more faster-moving, not as much of a focus on income, but really looking for that upward momentum. So, some of the factors we are using here; 12-month price change from their 12-month high. So, what it’s looking at is across the last 12 months, the highest price a stock has achieved, the difference from that to today and then you want a higher value for that. Three-month earnings per share estimate revision, similar to what we just saw. And then, some of the screen that we applied; quarterly earnings per share momentum. We want to have that to be in roughly the top half of peers. A minimum market cap just to get rid of any sort of low small-cap stocks that we may not want to be owning for low liquidity. And again, we also have minimum trading volume worked in as well to help with liquidity issues.

So, let's see how that combined portfolio looks together. First off, before we run our back test, we are just going to set our parameters. So, for this back test I'm going to use, again, that dividend growth model and them momentum model. We looked out and did a 50-50 allocation to each. I'm going to invest $2 million at the beginning, so $1 million for each model. And I'm running from December 1993 to March 2016. And each model is going to have 15 stocks.

So, let's see how this looked. So, what we're looking at here is the combined combination of both the dividend sleeve and the momentum sleeve. So, the performance that you are looking at on that purple line is actually 50% from the dividend sleeve and 50% from the momentum.

Okay. So, the pooled model produced a return of 14.6% annualized across that roughly 30-year time period. That will beat the benchmark which is the S&P 500 by 5.1% net. So, a pretty good margin there. Turnover was on the higher side at 153%. Again, what turnover is looking at is the number of times that you are trading stocks out of your model and replacing them. So, what that means is you’re placing your portfolio of 30 stocks, roughly 1.5 times in a year. So, you'd be trading those 30 stocks and then some on average across the year.

A couple of other metrics I like to look at, are this green and blue chart section here. In up markets, the pooled model outperformed 51% of the time relative to the benchmark. In down markets, it actually outperformed 75% of the time. So, the combination of the two sleeves seems to have done quite well in down markets.

Again, this is just another way that you can combine different types of styles of investing into one overall portfolio.

For Morningstar, I'm Emily Halverson-Duncan.